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American Style of Life [Constitution for the United States of America][1] We the People of the United States, in Order to form a more perfect Union, establish.

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Presentation on theme: "American Style of Life [Constitution for the United States of America][1] We the People of the United States, in Order to form a more perfect Union, establish."— Presentation transcript:

1 American Style of Life [Constitution for the United States of America][1] We the People of the United States, in Order to form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defence, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity, do ordain and establish this Constitution for the United States of America. Article. I. Section. 1. All legislative Powers herein granted shall be vested in a Congress of the United States, which shall consist of a Senate and House of Representatives. Section. 2. The House of Representatives shall be composed of Members chosen every second Year by the People of the several States, and the Electors in each State shall have the Qualifications requisite for Electors of the most numerous Branch of the State Legislature. No Person shall be a Representative who shall not have attained to the Age of twenty five Years, and been seven Years a Citizen of the United States, and who shall not, when elected, be an Inhabitant of that State in which he shall be chosen. Representatives and direct Taxes shall be apportioned among the several States which may be included within this Union, according to their respective Numbers, which shall be determined by adding to the whole Number of free Persons, including those bound to Service for a Term of Years, and excluding Indians not

2 taxed, three fifths of all other Persons [Modified by Amendment XIV]
taxed, three fifths of all other Persons [Modified by Amendment XIV]. The actual Enumeration shall be made within three Years after the first Meeting of the Congress of the United States, and within every subsequent Term of ten Years, in such Manner as they shall by Law direct. The Number of Representatives shall not exceed one for every thirty Thousand, but each State shall have at Least one Representative; and until such enumeration shall be made, the State of New Hampshire shall be entitled to chuse three, Massachusetts eight, Rhode-Island and Providence Plantations one, Connecticut five, New-York six, New Jersey four, Pennsylvania eight, Delaware one, Maryland six, Virginia ten, North Carolina five, South Carolina five, and Georgia three. When vacancies happen in the Representation from any State, the Executive Authority thereof shall issue Writs of Election to fill such Vacancies. The House of Representatives shall chuse their Speaker and other Officers; and shall have the sole Power of Impeachment. Section. 3. The Senate of the United States shall be composed of two Senators from each State, chosen by the Legislature thereof [Modified by Amendment XVII], for six Years; and each Senator shall have one Vote. Immediately after they shall be assembled in Consequence of the first Election, they shall be divided as equally as may be into three Classes. The Seats of the Senators of the first Class shall be vacated at the Expiration of the second Year, of the second Class at the Expiration of the fourth Year, and of the third Class at the Expiration of the sixth Year, so that one third may be chosen every second Year; and if Vacancies happen by Resignation, or otherwise, during the Recess of the Legislature of any State, the Executive thereof may make temporary Appointments until the next Meeting of the Legislature, which shall then fill such Vacancies [Modified by Amendment XVII]. No Person shall be a Senator who shall not have attained to the Age of thirty Years, and been nine Years a Citizen of the United States, and who shall not, when elected, be an Inhabitant of that State for which he shall be chosen.

3 The Vice President of the United States shall be President of the Senate, but shall have no Vote, unless they be equally divided. The Senate shall chuse their other Officers, and also a President pro tempore, in the Absence of the Vice President, or when he shall exercise the Office of President of the United States. The Senate shall have the sole Power to try all Impeachments. When sitting for that Purpose, they shall be on Oath or Affirmation. When the President of the United States is tried, the Chief Justice shall preside: And no Person shall be convicted without the Concurrence of two thirds of the Members present. Judgment in Cases of Impeachment s for raising Revenue shall originate in the House of Representativeshall not extend further than to removal from Office, and disqualification to hold and enjoy any Office of honor, Trust or Profit under the United States: but the Party convicted shall nevertheless be liable and subject to Indictment, Trial, Judgment and Punishment, according to Law. Section. 4. The Times, Places and Manner of holding Elections for Senators and Representatives, shall be prescribed in each State by the Legislature thereof; but the Congress may at any time by Law make or alter such Regulations, except as to the Places of chusing Senators. The Congress shall assemble at least once in every Year, and such Meeting shall be on the first Monday in December [Modified by Amendment XX], unless they shall by Law appoint a different Day.

4 Section. 5. Each House shall be the Judge of the Elections, Returns and Qualifications of its own Members, and a Majority of each shall constitute a Quorum to do Business; but a smaller Number may adjourn from day to day, and may be authorized to compel the Attendance of absent Members, in such Manner, and under such Penalties as each House may provide. Each House may determine the Rules of its Proceedings, punish its Members for disorderly Behaviour, and, with the Concurrence of two thirds, expel a Member. Each House shall keep a Journal of its Proceedings, and from time to time publish the same, excepting such Parts as may in their Judgment require Secrecy; and the Yeas and Nays of the Members of either House on any question shall, at the Desire of one fifth of those Present, be entered on the Journal. Neither House, during the Session of Congress, shall, without the Consent of the other, adjourn for more than three days, nor to any other Place than that in which the two Houses shall be sitting. Section. 6. The Senators and Representatives shall receive a Compensation for their Services, to be ascertained by Law, and paid out of the Treasury of the United States. They shall in all Cases, except Treason, Felony and Breach of the Peace, be privileged from Arrest during their Attendance at the Session of their respective Houses, and in going to and returning from the same; and for any Speech or Debate in either House, they shall not be questioned in any other Place. No Senator or Representative shall, during the Time for which he was elected, be appointed to any civil Office under the Authority of the United States, which shall have been created, or the Emoluments whereof shall have been encreased during such time; and no Person holding any Office under the United States, shall be a Member of either House during his Continuance in Office.

5 Section. 7. All Bills for raising Revenue shall originate in the House of Representatives; but the Senate may propose or concur with Amendments as on other Bills. Every Bill which shall have passed the House of Representatives and the Senate, shall, before it become a Law, be presented to the President of the United States;[2] If he approve he shall sign it, but if not he shall return it, with his Objections to that House in which it shall have originated, who shall enter the Objections at large on their Journal, and proceed to reconsider it. If after such Reconsideration two thirds of that House shall agree to pass the Bill, it shall be sent, together with the Objections, to the other House, by which it shall likewise be reconsidered, and if approved by two thirds of that House, it shall become a Law. But in all such Cases the Votes of both Houses shall be determined by yeas and Nays, and the Names of the Persons voting for and against the Bill shall be entered on the Journal of each House respectively. If any Bill shall not be returned by the President within ten Days (Sundays excepted) after it shall have been presented to him, the Same shall be a Law, in like Manner as if he had signed it, unless the Congress by their Adjournment prevent its Return, in which Case it shall not be a Law. Every Order, Resolution, or Vote to which the Concurrence of the Senate and House of Representatives may be necessary (except on a question of Adjournment) shall be presented to the President of the United States; and before the Same shall take Effect, shall be approved by him, or being disapproved by him, shall be repassed by two thirds of the Senate and House of Representatives, according to the Rules and Limitations prescribed in the Case of a Bill. Section. 8. The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States; To borrow Money on the credit of the United States; To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes; To establish an uniform Rule of Naturalization, and uniform Laws on the subject of Bankruptcies throughout the United States; To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures;

6 To provide for the Punishment of counterfeiting the Securities and current Coin of the United States; To establish Post Offices and post Roads; To promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries; To constitute Tribunals inferior to the supreme Court; To define and punish Piracies and Felonies committed on the high Seas, and Offences against the Law of Nations; To declare War, grant Letters of Marque and Reprisal, and make Rules concerning Captures on Land and Water; To raise and support Armies, but no Appropriation of Money to that Use shall be for a longer Term than two Years; To provide and maintain a Navy; To make Rules for the Government and Regulation of the land and naval Forces; To provide for calling forth the Militia to execute the Laws of the Union, suppress Insurrections and repel Invasions; To provide for organizing, arming, and disciplining, the Militia, and for governing such Part of them as may be employed in the Service of the United States, reserving to the States respectively, the Appointment of the Officers, and the Authority of training the Militia according to the discipline prescribed by Congress; To exercise exclusive Legislation in all Cases whatsoever, over such District (not exceeding ten Miles square) as may, by Cession of particular States, and the Acceptance of Congress, become the Seat of the Government of the United States, and to exercise like Authority over all Places purchased by the Consent of the Legislature of the State in which the Same shall be, for the Erection of Forts, Magazines, Arsenals, dock-Yards, and other needful Buildings; — And

7 To make all Laws which shall be necessary and proper for carrying into Execution the foregoing Powers, and all other Powers vested by this Constitution in the Government of the United States, or in any Department or Officer thereof. Section. 9. The Migration or Importation of such Persons as any of the States now existing shall think proper to admit, shall not be prohibited by the Congress prior to the Year one thousand eight hundred and eight, but a Tax or duty may be imposed on such Importation, not exceeding ten dollars for each Person. The Privilege of the Writ of Habeas Corpus shall not be suspended, unless when in Cases of Rebellion or Invasion the public Safety may require it. No Bill of Attainder or ex post facto Law shall be passed. No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken. No Tax or Duty shall be laid on Articles exported from any State. No Preference shall be given by any Regulation of Commerce or Revenue to the Ports of one State over those of another; nor shall Vessels bound to, or from, one State, be obliged to enter, clear, or pay Duties in another. No Money shall be drawn from the Treasury, but in Consequence of Appropriations made by Law; and a regular Statement and Account of the Receipts and Expenditures of all public Money shall be published from time to time. No Title of Nobility shall be granted by the United States: And no Person holding any Office of Profit or Trust under them, shall, without the Consent of the Congress, accept of any present, Emolument, Office, or Title, of any kind whatever, from any King, Prince, or foreign State.

8 Section. 10. No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility. No State shall, without the Consent of the Congress, lay any Imposts or Duties on Imports or Exports, except what may be absolutely necessary for executing it's inspection Laws; and the net Produce of all Duties and Imposts, laid by any State on Imports or Exports, shall be for the Use of the Treasury of the United States; and all such Laws shall be subject to the Revision and Controul of the Congress. No State shall, without the Consent of Congress, lay any Duty of Tonnage, keep Troops, or Ships of War in time of Peace, enter into any Agreement or Compact with another State, or with a foreign Power, or engage in War, unless actually invaded, or in such imminent Danger as will not admit of delay. Article. II. Section. 1. The executive Power shall be vested in a President of the United States of America. He shall hold his Office during the Term of four Years, and, together with the Vice President, chosen for the same Term, be elected, as follows: Each State shall appoint, in such Manner as the Legislature thereof may direct, a Number of Electors, equal to the whole Number of Senators and Representatives to which the State may be entitled in the Congress: but no Senator or Representative, or Person holding an Office of Trust or Profit under the United States, shall be appointed an Elector.

9 The Electors shall meet in their respective States, and vote by Ballot for two Persons, of whom one at least shall not be an Inhabitant of the same State with themselves. And they shall make a List of all the Persons voted for, and of the Number of Votes for each; which List they shall sign and certify, and transmit sealed to the Seat of the Government of the United States, directed to the President of the Senate. The President of the Senate shall, in the Presence of the Senate and House of Representatives, open all the Certificates, and the Votes shall then be counted. The Person having the greatest Number of Votes shall be the President, if such Number be a Majority of the whole Number of Electors appointed; and if there be more than one who have such Majority, and have an equal Number of Votes, then the House of Representatives shall immediately chuse by Ballot one of them for President; and if no Person have a Majority, then from the five highest on the List the said House shall in like Manner chuse the President. But in chusing the President, the Votes shall be taken by States, the Representation from each State having one Vote; a quorum for this Purpose shall consist of a Member or Members from two thirds of the States, and a Majority of all the States shall be necessary to a Choice. In every Case, after the Choice of the President, the Person having the greatest Number of Votes of the Electors shall be the Vice President. But if there should remain two or more who have equal Votes, the Senate shall chuse from them by Ballot the Vice President [Modified by Amendment XII]. The Congress may determine the Time of chusing the Electors, and the Day on which they shall give their Votes; which Day shall be the same throughout the United States. No Person except a natural born Citizen, or a Citizen of the United States, at the time of the Adoption of this Constitution, shall be eligible to the Office of President; neither shall any Person be eligible to that Office who shall not have attained to the Age of thirty five Years, and been fourteen Years a Resident within the United States. In Case of the Removal of the President from Office, or of his Death, Resignation, or Inability to discharge the Powers and Duties of the said Office, the Same shall devolve on the Vice President, and the Congress may by Law provide for the Case of Removal, Death, Resignation or Inability, both of the President and Vice President, declaring what Officer shall then act as President, and such Officer shall act accordingly, until the Disability be removed, or a President shall be elected [Modified by Amendment XXV].

10 The President shall, at stated Times, receive for his Services, a Compensation, which shall neither be increased nor diminished during the Period for which he shall have been elected, and he shall not receive within that Period any other Emolument from the United States, or any of them. Before he enter on the Execution of his Office, he shall take the following Oath or Affirmation: — "I do solemnly swear (or affirm) that I will faithfully execute the Office of President of the United States, and will to the best of my Ability, preserve, protect and defend the Constitution of the United States." Section. 2. The President shall be Commander in Chief of the Army and Navy of the United States, and of the Militia of the several States, when called into the actual Service of the United States; he may require the Opinion, in writing, of the principal Officer in each of the executive Departments, upon any Subject relating to the Duties of their respective Offices, and he shall have Power to grant Reprieves and Pardons for Offences against the United States, except in Cases of Impeachment. He shall have Power, by and with the Advice and Consent of the Senate, to make Treaties, provided two thirds of the Senators present concur; and he shall nominate, and by and with the Advice and Consent of the Senate, shall appoint Ambassadors, other public Ministers and Consuls, Judges of the supreme Court, and all other Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established by Law: but the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments. The President shall have Power to fill up all Vacancies that may happen during the Recess of the Senate, by granting Commissions which shall expire at the End of their next Session. Section. 3. He shall from time to time give to the Congress Information of the State of the Union, and recommend to their Consideration such Measures as he shall judge necessary and expedient; he may, on extraordinary Occasions, convene both Houses, or either of them, and in Case of Disagreement between them, with Respect to the Time of Adjournment, he may adjourn them to such Time as he shall think proper; he shall receive Ambassadors and other public Ministers; he shall take Care that the Laws be faithfully executed, and shall Commission all the Officers of the United States. Section. 4. The President, Vice President and all civil Officers of the United States, shall be removed from Office on Impeachment for, and Conviction of, Treason, Bribery, or other high Crimes and Misdemeanors.

11 Article. III. Section. 1. The judicial Power of the United States shall be vested in one supreme Court, and in such inferior Courts as the Congress may from time to time ordain and establish. The Judges, both of the supreme and inferior Courts, shall hold their Offices during good Behaviour, and shall, at stated Times, receive for their Services a Compensation, which shall not be diminished during their Continuance in Office. Section. 2. The judicial Power shall extend to all Cases, in Law and Equity, arising under this Constitution, the Laws of the United States, and Treaties made, or which shall be made, under their Authority; — to all Cases affecting Ambassadors, other public Ministers and Consuls; — to all Cases of admiralty and maritime Jurisdiction; — to Controversies to which the United States shall be a Party; — to Controversies between two or more States; — between a State and Citizens of another State [Modified by Amendment XI]; — between Citizens of different States; — between Citizens of the same State claiming Lands under Grants of different States, and between a State, or the Citizens thereof, and foreign States, Citizens or Subjects. In all Cases affecting Ambassadors, other public Ministers and Consuls, and those in which a State shall be Party, the supreme Court shall have original Jurisdiction. In all the other Cases before mentioned, the supreme Court shall have appellate Jurisdiction, both as to Law and Fact, with such Exceptions, and under such Regulations as the Congress shall make. The Trial of all Crimes, except in Cases of Impeachment, shall be by Jury; and such Trial shall be held in the State where the said Crimes shall have been committed; but when not committed within any State, the Trial shall be at such Place or Places as the Congress may by Law have directed. Section. 3. Treason against the United States shall consist only in levying War against them, or in adhering to their Enemies, giving them Aid and Comfort. No Person shall be convicted of Treason unless on the Testimony of two Witnesses to the same overt Act, or on Confession in open Court. The Congress shall have Power to declare the Punishment of Treason, but no Attainder of Treason shall work Corruption of Blood, or Forfeiture except during the Life of the Person attainted.

12 Article. IV. Section. 1. Full Faith and Credit shall be given in each State to the public Acts, Records, and judicial Proceedings of every other State. And the Congress may by general Laws prescribe the Manner in which such Acts, Records and Proceedings shall be proved, and the Effect thereof. Section. 2. The Citizens of each State shall be entitled to all Privileges and Immunities of Citizens in the several States. A Person charged in any State with Treason, Felony, or other Crime, who shall flee from Justice, and be found in another State, shall on Demand of the executive Authority of the State from which he fled, be delivered up, to be removed to the State having Jurisdiction of the Crime. No Person held to Service or Labour in one State, under the Laws thereof, escaping into another, shall, in Consequence of any Law or Regulation therein, be discharged from such Service or Labour, but shall be delivered up on Claim of the Party to whom such Service or Labour may be due [Modified by Amendment XIII]. Section. 3. New States may be admitted by the Congress into this Union; but no new State shall be formed or erected within the Jurisdiction of any other State; nor any State be formed by the Junction of two or more States, or Parts of States, without the Consent of the Legislatures of the States concerned as well as of the Congress. The Congress shall have Power to dispose of and make all needful Rules and Regulations respecting the Territory or other Property belonging to the United States; and nothing in this Constitution shall be so construed as to Prejudice any Claims of the United States, or of any particular State. Section. 4. The United States shall guarantee to every State in this Union a Republican Form of Government, and shall protect each of them against Invasion; and on Application of the Legislature, or of the Executive (when the Legislature cannot be convened), against domestic Violence.

13 Article. V. The Congress, whenever two thirds of both Houses shall deem it necessary, shall propose Amendments to this Constitution, or, on the Application of the Legislatures of two thirds of the several States, shall call a Convention for proposing Amendments, which, in either Case, shall be valid to all Intents and Purposes, as Part of this Constitution, when ratified by the Legislatures of three fourths of the several States, or by Conventions in three fourths thereof, as the one or the other Mode of Ratification may be proposed by the Congress; Provided that no Amendment which may be made prior to the Year One thousand eight hundred and eight shall in any Manner affect the first and fourth Clauses in the Ninth Section of the first Article; and that no State, without its Consent, shall be deprived of its equal Suffrage in the Senate. Article. VI. All Debts contracted and Engagements entered into, before the Adoption of this Constitution, shall be as valid against the United States under this Constitution, as under the Confederation. This Constitution, and the Laws of the United States which shall be made in Pursuance thereof; and all Treaties made, or which shall be made, under the Authority of the United States, shall be the supreme Law of the Land; and the Judges in every State shall be bound thereby, any Thing in the Constitution or Laws of any State to the Contrary notwithstanding. The Senators and Representatives before mentioned, and the Members of the several State Legislatures, and all executive and judicial Officers, both of the United States and of the several States, shall be bound by Oath or Affirmation, to support this Constitution; but no religious Test shall ever be required as a Qualification to any Office or public Trust under the United States. Article. VII. The Ratification of the Conventions of nine States, shall be sufficient for the Establishment of this Constitution between the States so ratifying the Same. The Word, "the," being interlined between the seventh and eighth Lines of the first Page, The Word "Thirty" being partly written on an Erazure in the fifteenth Line of the first Page, The Words "is tried" being interlined between the thirty second and thirty third Lines of the first Page and the Word "the" being interlined between the forty third and forty fourth Lines of the second Page. Attest William Jackson Secretary done in Convention by the Unanimous Consent of the States present the Seventeenth Day of September in the Year of our Lord one thousand seven hundred and Eighty seven and of the Independence of the United States of America the Twelfth In witness whereof We have hereunto subscribed our Names,

14 ECONOMICS AS RELIGION The most vital religion of the modern age has been economic progress. If economists have had a modest impact in actually generating this progress, or even understanding the actual mechanisms by which it has occurred, they have had a large role in giving it social legitimacy.They have been the modern priesthood of the religion of progress, interpreting its forms, refining its messages, and assuring the faithful that progress would continue.Without the blessings of an authoritative priesthood, all kinds of opportunistic and predatory forces are always lurking in wait in society, holding the potential to undermine the workings of the market as well as other core institutions. By promoting a culture of civic commitment to the market system, economists have put the power of religion to work in fending off these newer temptations of a modern kind of “devil.”

15 This should not be taken to suggest that professional economists have not
had a great deal of useful and practical advice to give. economists have been defending their professional status in society under false pretenses.The emperor of high economic theory has no clothes. Economists have been saying one thing as a matter of theory and doing another as a matter of the daily practice of economic policy—and the doing part has often yielded significant social benefits.If the objection might be raised that this assertion presupposes a subjective definition of “benefit,” the objection would be valid. However, the conclusion that economics can be useful in the policy arena requires only a minimal agreement on a desirable outcome—that health is better than illness, for example, or that being warm in winter is better than being cold.

16 However,these practical contributions of economists for the most part did
not require any great scientific apparatus.* The argument that “the market works”has been known for many centuries,even well before Adam Smith.It often amounts to little more than saying that a money system with prices for goods and services will outperform a barter system as an arrangement for their exchange—something recognized by all kinds of societies and stated in many times and places before modern “technical” economics. Historically, the greatest obstacle to the market is not a failure to understand its workings. Rather,the larger obstacles lie in two forms.First,many people have objected to the market for moral and ethical reasons—that is to say,they had strong religious (or quasi-religious) objections of one form or another to the wide scope for the expression of self-interest as found in the market. Second, the individual pursuit of opportunistic actions such as corruption and dishonest behavior—creating a climate in which “trust”does not exist in society—have the potential to undermine the efficient workings of markets.

17 Beyond these practical religious functions central to the role of economic
professionals in modern society, their other practical functions might be described as engaging in the “science of common sense.” As a matter of intellectual content, the basic economic principles of price theory could be learned in a few days if not hours. The resistance of many students is more moral than intellectual. If they must be exposed to many concrete examples that show how “the market works,” it is because there is a strong initial ethical predisposition to reject the message (one that many noneconomists never overcome). If the private pursuit of self-interest was long seen in Christianity as a sign of the continuing presence of sin in the world—a reminder of the fallen condition of humanity since the transgression of Adam and Eve in the Garden—a blessing for a market economy has appeared to many people as the religious equivalent of approving of the existence of sin.

18 Although the scientific content of economics is limited in its practical application,
the economics profession still requires years of study of economic theory to win full acceptance among its members .Part of this can be seen as developing a mastery of the religious artistry of economic progress—the capability of producing inspirational economic poetry in scientific language. Part of this long training period also serves to instill the ethics of economic professionalism involving a sense of commitment among economists to advance the common good. A further purpose of professional training is to require the budding economist to make a large investment of time and money—to offer a “hostage” that serves to “signal” his or her continuing commitment over the long run to the norms of the profession.

19 QUANTUM MECHANICS Quantum mechanics, especially its Heisenberg principle of indeterminacy, has been notable for the change it has brought in the physicist's epistemological theory of the relation of the experimenter to the object of his scientific knowledge. Perhaps the most novel and important thesis of this book is its author's contention that quantum mechanics has brought the concept of potentiality back into physical science. This makes quantum theory as important for ontology as for epistemology. What of determinism? Again, there is no agreed-upon convention among physicists and philosophers of science about how this word is to be used. It is in accord with the common-sense usage to identify it with the strongest possible causality. Let us, then, use the word "determinism" to denote only the stronger type of mechanical causation. Then I believe the careful reader will get the following answer to his question: In Newtonian, Einsteinian and quantum mechanics, mechanical, rather than teleological, causality holds. This is why quantum physics is called quantum mechanics, rather than quantum teleologies. But, whereas causality in Newton's and Einstein's physics is of the stronger type and, hence, both mechanical and deterministic, in quantum mechanics it is of the weaker causal type and, hence, mechanical but not deterministic. From the latter fact it follows that if anywhere Heisenberg

20 uses the words "mechanical causality" in their stronger, deterministic
meaning and the question be asked "Does mechanical causation in this stronger meaning hold in quantum mechanics?" then the answer has to be "No," It would be an error, therefore, if the reader, from Heisenberg's emphasis upon the presence in quantum mechanics of something analogous to Aristotle's concept of potentiality, concluded that contemporary physics has taken us back to Aristotle's physics and ontology. It would be an equal error conversely to conclude, because mechanical causation in its weaker meaning still holds in quantum mechanics, that all is the same now in modern physics with respect to its causality and ontology as was the case before quantum mechanics came into being. What has occurred is that in quantum theory contemporary man has moved on beyond the classical medieval and the modern world to a new physics and philosophy which combines consistently some of the basic causal and ontological assumptions of each. Here, let it be recalled, we use the word "ontological

21 to denote any experimentally verified concept of scientific theory
which refers to the object of scientific knowledge rather than merely to the epistemological relation of the scientist as knower to the object which he knows. Such an experimentally verified philosophical synthesis of ontological potentiality with ontological mechanical causality, in the weaker meaning of the latter concept, occurred when physicists found it impossible to account theoretically for the Compton effect and the results of experiment on black-body radiation unless they extended the concept of probability from its Newtonian and Einsteinian merely epistemological, theory-of-errors role in specifying when their theory is or is not experimentally confirmed to the ontological role, specified in principle in the theory's postulates, of characterizing the object of scientific knowledge itself.

22 When, however, the quantum
numbers of the system are large, then the quantitative amount of uncertainty specified by the Heisenberg principle becomes insignificant and the probability numbers in the state-function can be neglected. Such is the case with gross common-sense objects. At this point quantum mechanics with its basically weaker type of causality gives rise, as a special case of itself, to Newtonian and Einsteinian mechanics with their stronger type of causality and determinism. Consequently, for human beings considered merely as gross common-sense objects the stronger type of causality holds and, hence, determinism reigns also. Nevertheless, subatomic phenomena are scientifically significant in man. To this extent, at least, that the causality governing him is of the weaker type, and he embodies both mechanical fate and potentiality. There are scientific reasons for believing that this occurs even in heredity. Any reader who wants to pursue this topic beyond the pages of this book should turn to What Is Life?

23 by Professor Erwin Schrodinger, the physicist after
whom the time-equation in quantum mechanics is named. Undoubtedly, potentiality and the weaker form of causality hold also for countless other characteristics of human beings, particularly for those cortical neural phenomena in man that are the epistemic correlates of directly introspected human ideas and purposes. If the latter possibility is the case, the solution of a baffling scientific, philosophical and even moral problem may be at hand. This problem is: How is the mechanical causation, even in its weaker form, of quantum mechanics to be reconciled with the tdeological causation patently present in the moral, political and legal purposes of man and in the teleological causal determination of his bodily behavior, in part at least, by these purposes? In short, how is the philosophy of physics expounded by Heisenberg to be reconciled with moral, political and legal science and philosophy?

24 Thus, teleological causality arises as a special case of the merchanical
causality described by Heisenberg. Tthis will provide a physical theory of the neurological correlates of introspected ideas, expressed in terms of the teleologically mechanical causality, thereby giving an explanation of how ideas can have a causally significant effect on the behavior of men. Likewise, it will show how the ideas and purposes of moral, political and legal man relate to the theory of physical potentiality and mechanical causality so thoroughly described by Heisenberg.

25 TAXES Taxes are complicated. The U.S. federal tax code contains over three million words – about 6,000 pages. A casual browsing of the tax code’s table of contents offers a glimpse into the vast complexity of federal taxation. Entire sections of the tax code apply specifically to such topics as the taxation of vaccines, shipowners' mutual protection and indemnity associations, specially sweetened natural wines, and life insurance companies. Annual changes to the tax code imply that taxes will continue to become more complex even as politicians tout tax simplification. Taxes levied by other jurisdictions, such as states and cities, add further layers of complexity. Americans spend billions of hours each year working on their taxes, not to mention the costs of accountants and tax preparers. Tax policy has important economic consequences, both for the national economy and for particular groups within the economy. Tax policies are often designed with the intention of stimulating economic growth – although economists differ drastically about which policies are most effective at fostering growth. Taxes can create incentives promoting desirable behavior and disincentives for unwanted behavior. Taxation provides a means to redistribute economic resources towards those with low incomes or special needs. Taxes provide the revenue needed for critical public services such as social security, health care, national defense, and education.

26 Taxation is as much a political issue as an economic issue
Taxation is as much a political issue as an economic issue. Political leaders have used tax policy to promote their agendas by initiating various tax reforms: decreasing (or increasing) tax rates, changing the definition of taxable income, creating new taxes on specific products, etc. Of course, no one particularly wants to pay taxes. Specific groups, such as small-business owners, farmers, or retired individuals, exert significant political effort to reduce their share of the tax burden. The voluminous tax code is packed with rules that benefit a certain group of taxpayers while inevitably shifting more of the burden to others. Tax policy clearly reflects the expression of power in the U.S. – those without power or favor are left paying more in taxes while others reap the benefits of lower taxes because of their political influence. Broad attempts to reform the tax system have produced dramatic and sudden shifts in tax policy, generally motivated by political factors rather than sound economic theory. For example, the top marginal federal tax bracket on individual income in the U.S. dropped precipitously from 70% to 28% during the 1980s. Tax policy has clearly been used to promote political, as well as economic, agendas.

27 The Structure of Taxation in the United States
Tax Progressivity The overall system of taxation in the United States is progressive. By a progressive tax system, we mean that the percentage of income an individual (or household) pays in taxes tends to increase with increasing income. Not only do those with higher incomes pay more in total taxes, they pay a higher rate of taxes. For example, a person making $100,000 in a year might pay 25% of their income in taxes ($25,000 in taxes), while someone with an income of $30,000 might only pay a 10% tax rate ($3,000 in taxes). A tax system may also be regressive or proportional. A regressive tax system is one where the proportion of income paid in taxes tends to decrease as one’s income increases. A proportional tax system simply means that everyone pays the same tax rate regardless of income. A given tax system may display elements of more than one approach.

28 Reasons for Progressive Taxation
The overall tax system of the United States, and in most other countries, is progressive for a number of reasons. A progressive tax embodies the concept that those with high incomes should pay more of their income in taxes because of their greater ability to pay without critical sacrifices. By paying a tax, any household must forego an equivalent amount of spending on goods, services, or investments. For a high-income household, these foregone opportunities might include a second home, an expensive vehicle, or a purchase of corporate stock. A low-income household, by comparison, might have to forego basic medical care, post-secondary education, or vehicle safety repairs. As income increases, the opportunity costs of paying taxes tend to be associated more with luxuries rather than basic necessities. The ability-to-pay principle recognizes that a flat (or regressive) tax rate would impose a larger burden, in terms of foregone necessities, on low-income households as compared to high-income households. A progressive tax system is also a way to address economic inequalities in a society. A high degree of inequality can be lessened by taxing high-income households at a relatively higher rate than low-income households. But we also need to consider who receives the benefits derived from tax revenues to fully evaluate a tax system’s impact on inequality. If the benefits of programs funded by taxation primarily accrue to low-income households while high-income households pay the majority of taxes, then the tax system effectively operates as a transfer mechanism. Increasing the progressivity of the tax system or altering the distribution of benefits allows redistribution of economic resources.

29 You should also be aware that the benefits of public expenditures are not evenly distributed throughout society. There is also an economic argument for a progressive tax system – it may yield a given level of public revenue with the least economic impact. To see why, consider how households with different levels of income would respond to a $100 tax cut. A low-income household would tend to quickly spend the entire amount on needed goods and services – injecting $100 of increased demand into the economy. By comparison, a high-income household might only spend a fraction on goods and services, choosing to save or invest a portion of the money. The money that a high-income household saves or invests does not add to the level of demand for goods and services in an economy. In economic terms, we say that the marginal propensity to consume tends to decrease as income increases. So, by collecting proportionally more taxes from high-income households we tend to maintain a higher level of effective demand and more economic activity.

30 The federal income tax is the most visible, complicated, and debated tax in the U.S. The federal income tax was established with the ratification of the 16th Amendment to the U.S. Constitution in It is levied on wages and salaries as well as income from many other sources including interest, dividends, capital gains, self-employment income, alimony, and prizes. To understand the basic workings of federal income taxes, you need to comprehend only two major issues. First, all income is not taxable – there are important differences among “total income,” “adjusted gross income,” and “taxable income.” Second, you need to know the distinction between a person’s “effective tax rate” and “marginal tax rate.” Total income is simply the sum of income an individual or couple receives from all sources. For most people, the largest portion of total income comes from wages or salaries. Many people receive investment income from three standard sources: interest, capital gains, and dividends. Self-employment income is also included in total income, along with other types of income such as alimony, farm income, and gambling winnings. The amount of federal taxes a person owes is not calculated based on total income. Instead, once total income is calculated, tax filers subtract some expenses as non-taxable. To obtain adjusted gross income (AGI), certain out-of-pocket expenses are subtracted from total income. These expenses include individual retirement account contributions, moving expenses, student loan interest, tuition, and a few other expenses. AGI is important because much of the tax data presented by the Internal Revenue Service (IRS) are sorted by AGI. However, taxes are not calculated based on AGI either. Taxable income is basically AGI less deductions and exemptions. Deductions are either standard or itemized. The standard deduction is a fixed amount excluded from taxation – in 2003 the standard deduction was $4,750 for single individuals and $9,500 for married couples. Tax filers have the option of itemizing their deductions. To itemize, a tax filer adds up certain expenses made during the year including state taxes, real estate taxes, mortgage interest, gifts to charity, and major medical expenses. If the itemized deductions exceed the standard deduction, then the itemized total is deducted instead. Exemptions are calculated based on the number of tax filers and dependents. A single tax filer with no dependent children can claim one exemption. A married couple with no children can claim two exemptions. Each dependent child counts as one more exemption. Additional exemptions are given for being age 65 or over or blind. In 2003, each exemption excluded a further $3,050 from taxation.

31 Taxable income is obtained by subtracting the deduction and exemption amounts from AGI. This is the amount a taxpayer actually pays taxes on. However, the amount of tax owed is not simply a multiple of taxable income and a single tax rate. The federal income tax system in the U.S. uses increasing marginal tax rates. This means that different tax rates apply on different portions of a person’s income. The concept can be illustrated with an example using the 2003 tax rates. For a single filer, the first $7,000 of taxable income (not total income or AGI) is taxed at a rate of 10%. Taxable income above $7,000 but less than $28,400 is taxed at a rate of 15%. Taxable income above $28,400 but less than $68,800 is taxed at a rate of 25%. Income above $68,800 is taxed at higher marginal rates – 28%, 33%, and 35%. Not all income, however, is taxed at the same marginal rates. Investment income from capital gains has generally been taxed at a lower rate than income from labor. Dividend income used to be taxed at the same marginal rate as labor income but the Jobs and Growth Act of 2003 also taxes dividends at the lower capital gains rate. While the top marginal rate on labor income in 2003 was 35%, the top rate on capital gains and dividend income was only 15%. Given that the vast majority of investment income is earned by wealthy taxpayers, the lower rates on investment income has important implications for the progressivity of the federal income tax.

32 Social Insurance Taxes
Taxes for federal social insurance programs, including Social Security, Medicaid, and Medicare, are taxed separately from income. Social insurance taxes are levied on salaries and wages, as well as income from self-employment. For those employed by others, these taxes are generally deducted directly from their paycheck. These deductions commonly appear as “FICA” taxes – a reference to the Federal Insurance Contributions Act. Self-employed individuals must pay their social insurance taxes when they file their federal income tax returns. Social insurance taxes are actually two separate taxes. The first is a tax of 12.4% of wages, which is primarily used to fund Social Security. Half of this tax is deducted from an employee’s paycheck while the employer is responsible for matching this contribution. The other is a tax of 2.9% for the Medicare program. Again, the employee and employer each pay half. Thus, social insurance taxes normally amount to a 7.65% deduction from an employee’s wage (6.2% %). Self-employed individuals are responsible for paying the entire share, 15.3%, themselves.

33 There is a very important difference between these two taxes
There is a very important difference between these two taxes. The Social Security tax is due only on the first $84,900 (in 2002) of income. On income above $84,900, no additional Social Security tax is paid. In other words, the maximum Social Security tax in 2002 that would be deducted from total wages is $5,264 ($84,900 × 0.062). The Medicare tax, however, is paid on all wages. Thus, the Medicare tax is truly a flat tax while the Social Security tax is a flat tax on the first $84,900 of income but then becomes a regressive tax when we consider income above this limit. Consider the impact of social insurance taxes on two individuals, one making a salary of $30,000 and another making $300,000. The typical worker would pay 7.65% on all income, or $2,295, in federal social insurance taxes. The high-income worker would pay the maximum Social Security contribution of $5,264 plus $4,350 for Medicare (1.45% of $300,000) for a total social insurance tax bill of $9,614. Note that this works out to a 3.2% overall tax rate, or less than half

34 the tax rate paid by the typical worker
the tax rate paid by the typical worker. As the high-income individual pays a lower rate of taxation, we see that social insurance taxes are regressive. Federal Corporate Taxes Corporations must file federal tax forms that are in many ways similar to the forms individuals complete. Corporate taxable income is defined as total revenues minus the cost of goods sold, wages and salaries, depreciation, repairs, interest paid, and other deductions. Thus corporations, like individuals, can take advantage of many deductions to reduce their taxable income. In fact, a corporation may have so many deductions that it actually ends up paying no tax at all or even receives a rebate check from the federal government. Corporate tax rates, like personal income tax rates, are progressive and calculated on a marginal basis. In 2002, the lowest corporate tax rate, applied to profits lower than $50,000 was 15%. The highest corporate tax rate, applied to profits over $10 million was 35%. As with individuals, the effective tax rate corporations pay is lower than their marginal tax rate.

35 the tax rate paid by the typical worker
the tax rate paid by the typical worker. As the high-income individual pays a lower rate of taxation, we see that social insurance taxes are regressive. Federal Corporate Taxes Corporations must file federal tax forms that are in many ways similar to the forms individuals complete. Corporate taxable income is defined as total revenues minus the cost of goods sold, wages and salaries, depreciation, repairs, interest paid, and other deductions. Thus corporations, like individuals, can take advantage of many deductions to reduce their taxable income. In fact, a corporation may have so many deductions that it actually ends up paying no tax at all or even receives a rebate check from the federal government. Corporate tax rates, like personal income tax rates, are progressive and calculated on a marginal basis. In 2002, the lowest corporate tax rate, applied to profits lower than $50,000 was 15%. The highest corporate tax rate, applied to profits over $10 million was 35%. As with individuals, the effective tax rate corporations pay is lower than their marginal tax rate.

36 Federal Excise Taxes An excise tax is a tax on the production, sale, or use of a particular commodity. The federal government collects excise taxes from manufacturers and retailers for the production or sale of a surprising number of products including tires, telephone services, air travel, fossil fuels (including gasoline, diesel fuel, and aviation fuel), alcohol, tobacco, and firearms. Unlike a sales tax, which is evident as an addition to the selling price of a product, excise taxes are normally incorporated into the price of a product. In most cases, consumers are not directly aware of the federal excise taxes they pay. However, every time you buy gas, make a phone call, fly in a commercial plane, or buy tobacco products, you are paying a federal excise tax. For example, the federal excise tax on gasoline as of 2003 was about 18 cents per gallon. Federal excise taxes initially may appear to be an example of proportional taxation – everyone pays the same tax rate on goods subject to excise taxes. However, in practice excise taxes turn out to be regressive because lower-income households tend to spend a greater portion of their income on goods that are subject to federal excise taxes. This is particularly true for gasoline, tobacco, and alcohol products.

37 Federal Estate and Gift Taxes
The vast majority of Americans will never be affected by the federal estate or gift taxes. These taxes apply only to the wealthiest Americans. The estate tax is applied to transfers of large estates to beneficiaries. Currently, estates valued at less than $1 million ($2 million for couples) are totally exempt from the tax. The top marginal estate tax rate is 55% but, as with individual and corporate taxes, the effective tax rates on estate tend to be lower. Provisions of the estate tax laws reduce the tax burden for the transfer of small businesses and farms. The estate tax exemption amount is scheduled to increase over the next several years to $3.5 million ($7 million for couples) in In 2010, the estate tax is scheduled to expire but this expiration is only temporary – under current law the estate tax would be reinstated in 2011. The transfer of large gifts is also subject to federal taxation. The estate tax and gift tax are complementary because the gift tax essentially prevents people from giving away their estate to beneficiaries tax-free while they are still alive. In 2002, gifts under $11,000 were excluded from the tax. Similar to the federal income tax, the gift tax rates are marginal and progressive, with a maximum tax rate of 50%. The gift tax is also scheduled for temporary expiration in 2010. The estate and gift taxes are the most progressive element of federal taxation, paid exclusively by those with considerable assets. The majority of estate taxes are paid by a very small number of wealthy taxpayers. In 2000 over half of estate taxes were collected from estates worth more than $5 million, about 0.15% of all estates.

38 State and Local Taxes Like the federal government, state governments also rely on tax revenues to fund public expenditures and transfer programs. Like the federal government, state governments rely on several different tax mechanisms including income taxes, excise taxes, and [[corporate tax]es. Thus, much of the above discussion applies to the tax structures in place in most states. However, there are some important differences that deserve mention. First, nearly all states (45 as of 2003) have instituted some type of general sales tax. State sales tax rates range from 2.9% (Colorado) to 7.25% (California). A few states reduce the tax rate on certain goods considered to be necessities, such as food and prescription drugs. For example, the general sales tax in Illinois is 6.25% but food and drug sales are taxed at only 1%. Other states with sales taxes exempt some necessities from taxation entirely. In most states, localities can charge a separate sales tax. While local sales taxes are generally lower than state sales taxes, there are exceptions. In New York the state sales tax is 4% but local sales taxes are often higher than 4%. Unlike income taxes, sales taxes tend to be regressive. The reason is that low-income households tend to spend a larger share of their income on taxable items than high-income households. Consider gasoline – which tends to be a declining share of total expenditures as income rises. An increase in gas taxes impacts low-income households more than high-income households. Some states, such as Idaho and Kansas, offer low-income households a tax credit on their state income taxes to compensate for their regressive state sales taxes.

39 Forty-one states levy an income tax
Forty-one states levy an income tax. Most of these states have several progressive tax brackets (up to 10 rates) similar to the federal income tax. However, state income taxes tend to be much less progressive than the federal income tax. Six states have only one income tax rate, meaning that their income tax approaches a flat tax. Several more states have what is effectively a single tax rate because the top rate applies at a very low income. For example, Maryland’s top rate of 4.75% kicks in at only $3,000 of income. Another important distinction between the federal system of taxation and the taxes levied at state and local levels is use of property taxes. In fact, property taxes tend to be the largest revenue source for state and local governments. The primary property tax levied in the U.S. is a tax on real estate, including land, private residences, and commercial properties. Generally, the tax is an annual assessment calculated as a proportion of the value of the property, although the formulas used by localities differ significantly. Property taxes are commonly collected at a local level, but a share of property taxes is allocated for state purposes. Property taxes tend to be regressive, although less regressive than excise and sales taxes. The reason is that high-income households tend to have a lower proportion of their assets subjected to property taxes. While renters do not directly pay property taxes, most economists conclude that the costs of property taxes are largely passed on to renters in the form of higher rents.

Small business is a place where you can take your dog to the office whenever you choose.” Lots of important issues — from your financial situation to your desire to create a needed product or provide a needed service to your ability to be a jack-of-all-trades — should influence your decision to become an entrepreneur. Being a small-business owner doesn’t mean that you have to work 70 hours a week, make a six-figure income, or offer a unique product or service. Many successful small-business owners work at their craft 40 hours a week or less and some work part-time at their business in addition to holding a regular job. The vast majority of small-business owners provide products or services quite similar to what’s already in the marketplace and make reasonable but not extraordinary sums of money — and, thanks largely to the independence that small-business ownership offers, are perfectly happy doing so The basics of doing business are the same, no matter what size the business is: ✓ Sales: Boeing manufactures and sells airplanes; you sell lemonade. A sale is a sale no matter what the product or service is or how large or small the ticket price is. ✓ Cost of goods: Boeing buys parts for its vendors and suppliers; you buy lemons, sugar, and paper cups from the grocery store. ✓ Expenses: Boeing has employee wages and pension plans (or employee benefits); you have sign-making costs and bubble-gum expenditures to keep your employees happy (also a form of employee benefits).

41 ✓ Profit: Profit is what’s left over after Boeing subtracts the cost of its
goods and expenses from its sales; the same is true for your lemonade stand. Financial basics: The same whether you’re big or small Not only are the concepts of Business 101 — sales, cost of goods, expenses, and profit — the same for all businesses, regardless of size or product offering, but many associated financial basics are the same, too. Here’s what is meant: ✓ Accounts payable: Boeing owes money to its vendors who provide it with parts; you owe money to your local grocery store for supplies. ✓ Accounts receivable: Boeing has money due from its customers (major airlines and governments) that buy the company’s airplanes. You have money due to you from Mrs. Huxtable, who wandered by thirsty without her purse. ✓ Cash flow: Boeing has money coming in and going out through various transactions with customers and vendors (sometimes cash flows positively, sometimes negatively), and so do you. ✓ Assets: Boeing has its manufacturing plants and equipment, inventory, office buildings, and the like; you have your lemonade stand and cash box. ✓ Liabilities: Boeing owes suppliers money; you owe money to your local grocery store. ✓ Net worth: Net worth is what’s left over after Boeing subtracts what it owes (its liabilities) from what it owns (its assets). Ditto for your small-business enterprise.

42 The Small Business Administration defines
small business as any business with fewer than 500 employees. This seems a bit large. Consider this: With 200 employees, you have, say, 400 dependents, maybe 1,000 customers, and 100 or so of the business’s vendors all depending on you, trusting in you, and waiting for the mail to deliver their next check. That certainly isn’t small by most people's standards — not if you measure size in terms of responsibility anyway. For those of you who like to work with numbers, our definition of small business is any business with 100 employees or fewer, a category that includes more than 98 percent of all U.S. businesses. The latest year’s U.S. government figures show that the country is home to 27 million small businesses. Of those, approximately 21 million have no employees. Meanwhile, hundreds of thousands of new businesses open their doors each year.

43 This kind of growth is an indicator
of the appeal of owning a small business. (Or maybe it’s an indicator of the lack of appeal of working for someone else.) Not only do small businesses create opportunities for their owners, but they also create jobs. In fact, small firms create about three-quarters of the new jobs in the United States. What all these numbers mean is that small business isn’t really small — it’s large, diverse, and growing. Not only is small business not small when speaking in terms of the sheer numbers of small businesses and their employees, it’s also not small when talking about the tenacity and knowledge required to start and run a small business.

44 Answering the questions
After reading each question, write your response from 1 to 5 on a separate sheet of paper. 1. In the games that you play, do you play harder when you fall behind, or do you have a tendency to fold your cards and cut your losses? (5 if you play harder, 1 if you wilt under pressure) 2. When you go to a sports event or concert, do you try to figure out the promoter’s or the owner’s gross revenues? (5 if you often do, 1 if you never do) 3. When things take a serious turn for the worse, is your first impulse to look for someone to blame, or is it to look for alternatives and solutions? (5 if you look for alternatives and solutions, 1 if you look for someone to blame) 4. Using your friends and/or coworkers as a barometer, how would you rate your energy level? (5 if it is high, 1 if it is low) 5. Do you daydream about business opportunities while commuting to work, flying on an airplane, waiting in the doctor’s office, or during other quiet times? (5 if you often do, 1 if you never do) 6. Look back on the significant changes you’ve made in your life — schools, jobs, relocations, relationships: Have you fretted and worried about those changes and not acted, or have you looked forward to them with excitement and been able to make those tough decisions after doing some research? (5 if you’ve looked forward to the decisions and tackled them after doing your homework, 1 if you’ve been overwhelmed with worry about the change and paralyzed from action for too long) 7. Is your first consideration of any opportunity always the upside or is it always the downside? (5 if you always see the upside and recognize the risks, 1 if you dwell on the downside to the exclusion of considering the benefits)

45 8. Are you happiest when you’re busy or when you have nothing to do? (5
if you’re always happiest when busy, 1 if you’re always happiest when you have nothing to do) 9. As an older child or young adult, did you often have a job or a scheme or an idea to make money? (5 if always, 1 if never) 10. Did you work part-time or summer jobs as a youth, or did you not work and primarily recreate/enjoy a total break over the summer? (5 if you often worked, 1 if you never did) 11. Did your parents own a small business? (5 if they worked many years owning small businesses, 1 if they never did) 12. Have you worked for a small business for more than one year? (5 if you have, 1 if you haven’t) 13. Do you like being in charge and in control? (5 if you really crave those two situations, 1 if you detest them) 14. How comfortable are you with borrowing money to finance an investment, such as buying a home or an automobile? (5 if owing money is not a problem, 1 if it’s a huge problem) 15. How creative are you? (5 if extremely creative, 1 if not creative at all) 16. Do you have to balance your checkbook to the penny or is “close” good enough? (5 if “close” is good enough, 1 if to the penny) 17. When you fail at a project or task, does it scar you forever or does it inspire you to do it better the next time? (5 if it inspires you for the next time, 1 if it scars you forever) 18. When you truly believe in something, whether it’s an idea, a product, or a service, are you able to sell it to someone? (5 if almost always, 1 if never) 19. In your current social and business environment, are you most often a follower or a leader? (5 if almost always a leader, 1 if always a follower) 20. How good are you at achieving/keeping your New Year’s resolutions? (5 if you almost always achieve/keep them, 1 if you never do)

46 Scoring the test Now total your score. Here’s how to assess your total: 80 to 100: Go for it. If you read this book and continue to show a willingness to be a sponge, you should succeed! 60 to 79: You probably have what it takes to successfully run your own business, but take some time to look back over the questions you scored the lowest on and see whether you can discern any trends. 40 to 59: Too close to call. Review the questions on which you scored low and don’t scrimp on learning more to tilt the scales in your favor. 20 to 39: We could be wrong, but you’re probably better off working for someone else or pursuing one of the other alternatives to starting your own business. Analyzing your results The truth about a subjective test such as this one is that it can serve as a helpful indicator, but it won’t provide you with a definitive answer. The Small-Business Owner’s Aptitude Test is, in effect, a measure of the way you have acted in the past and not necessarily how you will perform in the future. Your future as a small-business owner will hold many surprises.The skills and traits that you need to cope with those surprises will ultimately determine whether your choice to start or buy a small business is the right one. What exactly are those skills? ✓ Numbers skills: These skills include those related to borrowing money, accounting for it, and reporting on the financial performance of your company. ✓ Sales skills: As a small-business owner, you’re always trying to sell your products to someone — be it your customers, employees, or vendors. ✓ Marketing skills: All small-business owners have to market their products or services — no one is exempt. ✓ Leadership skills: The small-business owner is the Grand Poobah of his venture. Grand Poobahs are only as good as the manner in which the business’s employees are led.

47 Does this mean that if you don’t have these skills, you should remain on the
receiving end of a paycheck? Thankfully, it does not. Many successful entrepreneurs who have come before you made it without being able to personally perform all the skills necessary to run a business. So, over the course of your career, you’ll have to either develop these skills or involve someone in the business who already has them (a partner, a key employee, or a hired advisor or consultant, for example). Skills aside, successful entrepreneurs also need to have or adopt several required traits: ✓ Confidence: Small-business owners have to be able to coexist with risk and possibly debt. Capitalism offers its participants no guarantees; thus, the small business and consequently its owner are almost always at risk and sometimes in debt. Yet, the owner still has to sleep at night. ✓ Intuition: Call it intuition or call it gut instinct, the small-business owner has to call things right more often than wrong, or he’ll soon be calling it quits. ✓ Optimism: Successful small-business owners often see good fortune, not misfortune; upsides, not downsides; and opportunities, not problems. The small-business owner can always hire a devil’s advocate (that’s what lawyers and accountants are for), but the enthusiasm and optimism necessary to drive the vision must come from the entrepreneur. ✓ Drive: Successful small-business owners are driven to create a product, service a customer, and build a successful business. Similar to the craving for chocolate, this drive doesn’t go away. ✓ Passion: An entrepreneur’s passion is infectious. Your employees, your vendors, and your customers — everyone you come in contact with — should feel your passion and feed off it. If you don’t have all five of these traits, should you resign yourself to always being an employee? In answering this question, you first need to recognize that being a good employee today also requires some of these traits, so owning a business isn’t your only option. Then you need to come to terms with the fact that if you don’t have most of these traits in healthy supply, you’re probably better off as an employee rather than a small-business owner.

48 The reasons to own There may be many reasons to give your boss the heave-ho. In this section, though, the best reasons are given for why people should choose to own a business: ✓ The satisfaction of creation: Have you ever experienced the pride of building a chair, preparing a gourmet meal, or repairing a vacuum cleaner? Or how about providing a needed counseling service that helps people solve their vexing financial problems? The small-business owner gets to experience the thrill of creation on a daily basis, not to mention the satisfaction of solving a customer’s problem. ✓ Establishment of their own culture: No more standing around the water cooler complaining about “the way things are around here.” After you start your own business, the way things are around here is a direct function of the way you intend them to be. ✓ Financial upside: Consider Charles Schwab and Oprah Winfrey. It’s no surprise that these one-time small-business owners are among the nation’s wealthiest individuals. (A recent Small Business Administration study concluded definitively that although small-business ownership is risky, smallbusiness owners had a significantly higher probability of being classified as high income and high wealth than their employed counterparts.) ✓ Self-sufficiency: For many people, working for someone else has proven to be a less-than-gratifying experience. As a result of such unfulfilling experiences, some people have discovered that if they want to provide for themselves and their families, they’d better create the opportunity themselves. It’s either that or be willing to occasionally spend a long wait in the unemployment line. ✓ Flexibility: Perhaps you prefer to work in the evenings because that’s when your spouse works or you want to spend more time with the kids during the day. Or you may prefer taking frequent three-day-weekend jaunts rather than a few full-week vacations every year. As a small-business owner, despite the long hours you work, you should have more control over your schedule. After all, you’re the boss, and you can usually tailor your schedule to meet your personal needs, as well as those of your customers. ✓ Special perks: Small-business owners have several advantages over the typical employee. For example, small-business owners can sock away tens of thousands of dollars into their retirement accounts per year free of federal and state income taxes. And yes, similar to those corporate execs who wine and dine their clients and then write off the expenses, small-business owners also have the option of writing off such costs as long as they adhere to IRS rules.

49 The reasons not to own In light of the resounding potential benefits, why would any reasonable soul elect to continue receiving a paycheck? Why wouldn’t everyone want to own a business? Let us count the nays: ✓ Responsibility: When you’re a small-business owner, not only does your family depend on your business success, but so do your partners, your employees and their families, your customers, and sometimes your vendors. As much as we love our small businesses, every now and then even the most enthusiastic small-business owners wax nostalgic for the good old days when they would punch their time card and leisurely walk out the door — really, truly, done for the day. If you’re the type of person who sometimes takes on more responsibility than you can handle and works too many hours, beware that another drawback of running your own business is that you may be prone to becoming a workaholic. ✓ Competition: Although some people thrive on competition, that same competition comes back to haunt you by threatening your security. You soon find out that a host of hungry competitors is pursuing your customers and threatening your livelihood, whether by cutting prices or offering a more complete package of unique services. Sure, competition is what makes capitalism go ’round, but you need to remember that in order to have a competition, someone’s going to win and someone’s going to lose. That someone could be you. ✓ Change: Products and services come, and products and services go. Nothing is sacred in the business of doing business, and the pace of change today is significantly faster than it was a generation ago — and it shows no signs of slowing down. If you don’t enjoy change and the commotion it causes, then perhaps the stability that a larger, more bureaucratic organization provides is best for you. ✓ Chance: Interest rates, the economy, theft, fire, natural disasters, sickness, pestilence — the list goes on. Any of these random events can send your business reeling. ✓ Red tape: Taxes, health-care reform, bureaucracy, tariffs, duties, treaties, OSHA, FDA, NAFTA, glurg, glurg, glurg. ✓ Business failure: Finally, as if this list of a small business’s enemies isn’t long enough, the owner faces the specter of the ultimate downside: business failure in the form of bankruptcy. This is the stage where the owner stands back and watches the creditors swoop in like vultures to devour his remaining business — and sometimes personal —

50 Ask yourself this important and (we hope) revealing question: “How
many businesses have I purchased in my lifetime?” If you’re like most people we know, the answer is a big, fat zero. Now, you’re an intelligent and discerning person, we firmly believe that, when buying a business, you’ll benefit from retaining the services of experts with extensive small-business deal-making experience. Negotiating is a skill that improves with experience. Experienced advisors can help you inspect the business you’re buying and look for red flags in the company’s financial statements. Advisors can also help structure the purchase to protect what you’re buying and to gain maximum tax benefits. To get the best deal, you need to do a number of things well, the first of which is to put a realistic and accurate value on the business you intend to buy. This is where we'll start and then move on to cover how to decide on the purchase price, how to do due diligence, and how to start off strong after you become the owner.

51 Valuing the Business When you begin exploring businesses for sale, you don’t know exactly what a given business is worth and you risk overpaying for that business if you jump into a deal too soon. However, with time and the right resources, combined with a little investigative work, you can get a good handle on a particular business’s worth, which may or may not be close to the owner’s asking price. You can start by taking a cue from smart home buyers and real estate investors: To find out how much a property is really worth, consider comparable sales — that is, the amounts that similar properties have sold for. Compared to business buyers, however, home buyers have it relatively easy. Real estate transactions are a matter of public record; small-business sales aren’t. So you have to do some extra sleuthing to find the specific price and terms of comparable businesses that have sold. In the end, however, after you’ve done the math and developed a dollar value for the business, remember one thing: Similar to buying a house, the real worth of a business is what you, or someone else, will pay for it. A business isn’t a car with a factory sticker price; it’s a multidimensional, complicated organization of people, assets, and systems. Its true value is in the eyes of the beholder, and the beholder is you. The following sections walk you through the process of valuing a business. You won’t have to go through every step (especially if you hire a business broker to manage the process for you), but each one is a viable option to consider.

52 Exploring valuing methods: Multiple of
earnings and book value Many methods exist for valuing a business. Some are unnecessarily complicated; others won’t provide you with sensible answers. For example, some advisors and business brokers advocate using a multiple of revenue to determine the value of a business — that is, if a business has $300,000 in revenues, it may be valued at $450,000 (a multiple of 1.5 times revenue). However, revenue is a poor proxy for profitability. Two businesses in the same field can have identical revenue yet quite different profitability due to the efficiency of their operations, the pricing of their products and services, and the types of customers they attract. Also, the multiple of revenue that a business may be worth varies depending on what industry the business is in. For example, the multiple for a manufacturing business is higher than the multiple for a retail establishment or a restaurant.

53 Other measures are more exact
Other measures are more exact. Here are some preferred valuation measures for small businesses: ✓ Multiple of earnings: When you compare the sales data for comparable companies to the sales data for the one you’re interested in buying, determine what multiple of earnings these businesses sold for. Divide the price the business sold for by its annual pre-tax earnings (profits) to arrive at the multiple of earnings (also known as the price-earnings ratio) of that transaction. When the multiple is low, say 3 to 1 (for example, if the business had earnings of $50,000 and a selling price of $150,000), the buyer and seller don’t have great expectations for the business’s future earnings. However, when the multiple is high, say 12 to 1 (if the business had earnings of $50,000 and a selling price of $600,000), the buyer’s and seller’s expectations of future earnings are correspondingly high. Future earnings are what will provide the return on the buyer’s investment; therefore, the higher the buyer expects those potential earnings to be, the more he or she is willing to pay for the business. (In general, a business should be able to pay for itself in three to five years. If the time period is any longer than that, you’re probably paying too much for the company.) Small, privately held businesses typically sell for lower multiples of earnings than larger companies in the same line of business. The reason: Small companies are less established and are riskier from an investing standpoint. Plus, your investment in their stock will be illiquid (that is, even in good times, the stock generally can’t be converted into cash within a reasonable period of time).

54 ✓ Book value: In addition to looking at the sales price of other businesses
relative to earnings, you can consider the value of a company’s assets. The book value of a company is the company’s assets minus its liabilities, which is the same as the net worth of the business as stated on its balance sheet. (We’re assuming here that the values for the assets and liabilities on the balance sheet are accurate.) The figures that go into determining book value should be checked carefully to ensure that the underlying asset values and liability accounts are correct. Of these two approaches, each of which has advantages as well as imperfections, the multiple-of-earnings approach is generally considered to be far superior to the book-value method. After all, what you’re purchasing when you buy a business isn’t primarily its assets but rather its ability to generate profits (earnings), using those assets. Some businesses, such as consulting firms, have little in the way of tangible assets — the personnel may be the firm’s greatest asset, and valuing that is difficult. Because the determination of a price-earnings multiple figure is based on an income-generating formula, it’s generally a better indicator than the book-value approach, which simply measures the difference between assets and liabilities

55 Keep in mind that the figure you come up with when using the multiple-ofearnings
approach represents the goodwill portion of the business only and doesn’t include the value of the business’s assets. (Goodwill is, in essence, the value of the business’s reputation and existing customer list.) Thus, you have to add the value of the assets to the goodwill number. The assets involved in a typical small-business purchase include accounts receivable (make sure that they’re all collectable), inventory (make sure that what you’re buying is merchantable), and equipment, furniture, and fixtures (the fair market value thereof). Getting a professional appraisal Business appraisers make a living out of estimating the value of businesses. If you want to buy a business and your initial investigation suggests that the seller is committed and serious about selling the business, consider hiring an appraiser. Although the fees professional appraisers charge vary depending on the size and complexity of the prospective business, you can usually expect to pay somewhere north of $5,000 for the typical small business. Tax advisors, lawyers, and business consultants who specialize in working with small businesses may be able to refer you to a good business appraiser if they can’t do the appraisal themselves. The Institute of Business Appraisers ( ) can provide you with a list of association members in your area. Also, check the business-to-business Yellow Pages in your area under “Appraisers — Business.” Tracking businesses you’ve explored that have sold If your search for a business to buy lasts months or perhaps years, keep track of similar businesses you’ve considered that eventually sell. These sales provide valuable comparables because you’ve seen the businesses up close and have obtained details about their financial position that give you perspective in assessing the sales. Obtaining the final selling price of a small business can be challenging. You can try asking the ex-owner, or you can speak with advisors or business brokers who are involved in such deals.

56 Tapping the knowledge of advisors who
work with similar companies Business consultants, attorneys, and tax advisors you work with can assist you with pinning down sales data for companies comparable to the one you’re considering buying. The key is to find advisors who have knowledge of, and experience with, both small businesses in general and businesses similar to the one you’re thinking of buying. If you end up buying a small business, you’ll benefit from having competent advisors on your team who have worked on comparable deals. But before you hire an advisor for tax, legal, or business advice, be sure to check references. Also ask the advisor for a comprehensive list of business deals (including the purchase or sale price and the industry) that he has been involved in over the past year. Don’t be deterred by the cost of such advisors, especially tax advisors and attorneys. The terms you agree to in the purchase of a business will be with you for a long, long time. Consulting research firms and publications Finding the details on similar companies that have sold can be difficult. Wouldn’t it be helpful if a service compiled such information for you? Well, you’ll be happy to know that some companies do publish comparable sales information or conduct company searches for a fee. One such company, BIZCOMPS, releases an annual publication that provides sales price, revenue, and other financial details for businesses sold. This compendium of sales information is available for different major regions and industries in the United States (Western, Eastern, Industrial, and Food Service). Visit or call for a sample of this publication. Each directory sells for $165. The company also offers online access to business sales data through an annual membership fee (which varies). Turning to trade publications Trade publications can help you find out more about a particular industry, as well as how to value companies within that industry. Most publications are willing to send you past articles on a topic, typically for a small fee. Or you may be able to access articles from the publication’s website.

57 Enlisting the services of a business broker
If you’re already working with a business broker (a salesperson who lists small businesses for sale and who works with buyers as well) or looking at a business listed for sale through a business broker, the broker should be able to provide a comparable market analysis of similar businesses that the broker’s office has sold. Don’t put too much weight on a business broker’s analysis. Unfortunately, a broker’s “analysis” may be less analytic and more sales oriented than you want. After all, business brokers earn commissions based on a percentage of the selling price of the business that you may buy through them. (The commissions generally range from 6 to 10 percent, depending on the size and complexity of the deal.) Also, understand that business brokers generally have access to sales data only on the small number of similar businesses that their particular office has sold. Unlike real estate agents, business brokers who work for different brokerage firms in a given community don’t share their sales data with one another. Before enlisting the services of a broker, be sure to check her references carefully — especially given the fact that business brokers are in a virtually unregulated industry that requires no specific credentials or educational training to enter. Be sure to involve your own attorney when the closing comes around. Having your own attorney takes the broker’s bias out of the equation and helps ensure that what you get is best for you. You can generally depend on your attorney to represent your best interests; the same cannot be said about your business broker.

58 Developing Purchase Offer Contingencies
When you make an offer to buy a home, you generally make your purchase offer contingent upon (dependent on) obtaining mortgage loan approval, satisfactory inspections, and proof that the property seller holds a clear title to the home. When you make an offer to buy a business, you need to make your purchase contingent upon similar issues, including the following: ✓ Inspections and due diligence: Your purchase offer for a business should be contingent upon a thorough review of the company’s financial statements and interviews of key employees, customers, and suppliers (this overall evaluation is called due diligence). You should be allowed to employ whomever you like to help you with your evaluation. The typical period of time allowed for due diligence is 30 to 60 days, more if the business is large.

59 ✓ Financing: Unless you’re paying cash for the full purchase price of the
business (which would be unusual), another condition of your purchase offer may be an acceptable seller-provided loan. Sellers can be a great financing source, and many are willing to lend you money to purchase their business. Seller financing is quite common in small-business purchases; in fact, about 90 percent of all small-business sales include seller financing. Yes, occasionally partial financing for a business purchase can come from traditional lending sources (banks, relatives, friends, angel investors, and so on), but the seller is always your number one opportunity. Think about it: If your seller still has “skin in the game,” he’s that much more motivated for you to succeed, which means he’ll be that much more likely to help you through the transition period. Be sure to compare the terms that the seller is offering to those of some local banks that specialize in small-business loans. In the purchase offer, specify the acceptable loan terms, including the duration of the loan and the maximum interest rate. If interest rates jump before your loan is finalized, you don’t want to be forced to complete your deal at too high of an interest rate. ✓ Noncompete clause: You don’t want to buy a business only to have the former owner set up an identical one down the block and steal his previous customers from you. To avoid this unpleasant possibility, be sure that your purchase offer includes a noncompete clause that states that the seller can’t establish a similar business within a certain nearby geographic area for a minimum number of years — or something like that. You may consider asking the owner, as part of the purchase deal, to make himself available to consult with you, at a specified hourly rate, for 6 to 12 months to make sure that you tap all his valuable experience, as well as to transition relationships with key employees, vendors, and customers. To further align the selling owner’s interests with yours, consider having a portion of the total purchase price dependent on the future success of the company. If the transaction includes seller financing, most sophisticated sellers want to continue to work with you for a period following the sale to help you get off on the right foot. Beware of those who don’t want to hang around. ✓ Limited potential liabilities: When you buy a business, you buy that business’s assets and usually (but not always) its liabilities. Some potential liabilities don’t show up on a company’s balance sheet and could become a thorn in your side. Make sure that the seller is liable for environmental cleanup and other undisclosed existing liabilities (debts). Conduct legal searches for liens, litigation, and tax problems. (Your attorney should conduct these searches for you as a part of the closing process.)

60 Allocating the Purchase Price
When you pay $300,000 for a business, you’re not simply paying $300,000 for the business. You’re paying, for example, $60,000 for the inventory, $40,000 for the accounts receivable, $50,000 for the company equipment, $100,000 for goodwill, and so on. No matter how you determine the purchase price, you must always break down that price, or allocate it, among the assets of the business and other categories. This requirement applies whether you set the price of the business by determining the value of its assets (such as through the multiple-ofearnings method) or by using someother method. Although allocating assets may cause your eyes to glaze over, snap to attention when the subject comes up, because how you structure the purchase can save you tens of thousands of dollars in taxes. Experienced tax advisors will tell you that you generally want to allocate much of the purchase price to specific assets of the business. Some assets are what their numbers make them out to be (such as accounts receivable), while others can be negotiable (such as equipment and goodwill). The reason for the negotiation is that different assets can be written off (or depreciated) over different periods of time. For instance, equipment can be depreciated over as little as 4 years, while goodwill takes 15 years to depreciate. You must report the purchase of the business and the allocation of the purchase price among business assets on IRS Form 8594 (Asset Acquisition Statement). Make sure that you do so, because if you don’t, the penalty is stiff — up to 10 percent of the amount not reported. Doing Due Diligence After spending months searching for the right business to buy and finding one that fits your fancy, you may well spend weeks negotiating an acceptable deal. Just as you’re about to stumble across what you think is the finish line, you realize you have plenty more work left to go. After all, now is the time to get out the microscope and really nitpick. Before you go through with the deal and fork over the dough, you have one last chance to discover any hidden problems that exist within the business you hope to buy. Of course, all businesses have their warts, but better for you to uncover them now so that the purchase price and terms reflect those warts

61 The process of thoroughly investigating your prospective business is called
due diligence. During due diligence, you need to answer important questions like these: ✓ Is the business as profitable as the financial statements indicate? ✓ Will the business’s customers remain after a change in ownership? ✓ What lease, debt, or other obligations will you be assuming when you buy the business? Due diligence typically lasts for 30 to 60 days, depending on the complexity of the company you’re hoping to purchase. The same experts you’re working with to put together a good deal for your small-business purchase will form your due-diligence team. Think about income statement issues The profitability of the business is probably the single most important aspect you need to consider during due diligence. To help you deal with income statement concerns, you should take the following steps: ✓ Have an experienced small-business tax advisor review the company’s financial statements. She’ll know what to look out for. Just be sure to agree on a budget for the cost of the advisor’s services (and, therefore, the time she will spend) upfront. ✓ Adjust for one-time events. If necessary, factor out one-time impactful events from the profit analysis. For example, if the business got an unusually large order last year that is unlikely to be repeated, subtract the amount of that order from the profitability analysis. ✓ Check the owner’s compensation. Examine the owner’s salary to see whether it’s too high or low for the industry the business is in. Owners can pump up the profitability of their company in the years before they sell by reducing or keeping their salary to a minimum or by paying family members in the business less than fair-market salaries.

62 ✓ Consider how the building expense will change. Consider whether the
rent or mortgage expense will be different after you buy the business. Any large change in that cost will clearly affect the profitability of the business. ✓ Factor in financing expenses. Be sure to calculate what will happen to profits when you factor in the financing costs from borrowing money to buy the business. ✓ Pay attention to trends. How are the sales and the profits trending? If this year’s profits were, say, $80,000 and last year’s were $100,000, the trend is unfavorable. On the other hand, if this year’s profits were $70,000 and last year’s were $50,000, you’re looking at a good trend. Knowledgable buyers are generally willing to pay a higher multiple for favorable trends. Consider legal and tax concerns Before you make a deal, follow these steps to research any legal or tax issues the business may have: ✓ Look for liens. Check to make sure that no liens are filed against assets of the business and, if you’re buying real estate, that the property title is clear. A competent attorney can help with this tedious and important legal task. ✓ Get proof that all taxes are paid. Get the seller to provide proof, certifying that federal and state employment, sales, and use taxes are all paid up. Moving Into Your Business If you’ve made it through the searching, researching, negotiating, and closing phases, you’re now a bona fide small-business owner. Congratulations and welcome to your new business! You’ve completed a lot of challenging and important work and should feel proud of yourself. After your deal is closed, be sure to take care of the following tasks as soon as possible: ✓ Disclose ownership transfer. Notify creditors of the transfer of ownership. In the counties where the company does business, publish a transfer-of-ownership notice in a general circulation newspaper. If you omit this step, you risk having unsecured creditors come after your business for outstanding debts that the previous owner had.

63 ✓ Write a business plan and mission statement or refine your plan if
you’ve already started it. If you researched the industry and evaluated in detail the business you bought, you should be able to generate a good business plan, including an applicable mission statement, without too much hassle. Although completing your business plan will take some time and thinking, doing so early on in the process will benefit you and your business in increased sales, reduced costs, and happier employees. If you ever intend to seek outside capital from a banker or investor, you’ll need a good business plan. Note: An ideal time to begin work on this business plan is during the due-diligence phase. ✓ Plan the company’s finances. Going forward, you need to have a firm handle on the revenue, expenses, and cash flow of your business. For example, you need to set up a budget for your business and forecast future needs for capital, both of which should be included in the business plan. ✓ Consider the entity/legal form of organization. Just because the business you bought was structured as a sole proprietorship or corporation doesn’t mean that legal entity makes the most sense for you. Your attorney and tax advisor should be part of this decision. ✓ Spend time understanding your customers. Get to know your best customers as soon as the ink is dry on the sales agreement. Without good customers who buy profitable products and services and who pay their bills on time, you don’t have a viable long-term business. Even the best business is bound to lose customers for a variety of reasons beyond the business owner’s control. So don’t skimp on understanding your customers’ needs, particularly what makes them buy your company’s wares and what their ongoing customer service needs are. Completing your business plan can help you clarify many of these vital issues. Plus, you can get a feel for how to market your products and services to customers and how to keep your customers loyal. ✓ Get to know your employees. Employees who liked the previous owner(s) will take time to warm up to you. Some employees may fear for their jobs or worry that a change in ownership will lead to reduced job satisfaction. Err on the side of doing more listening to your employees rather than always being the one jabbering about all your grand plans. The employees contain a wealth of knowledge about the business from which you can learn, and the better you listen, the more the employees will grow to respect and like you.

64 structure (see Chapters 16 and 17). Don’t make rash changes in this
area, especially if you’re thinking about reducing benefits and/or compensation. Early, negative changes can have ugly long-term consequences. ✓ Walk; don’t run. Don’t make huge changes your first day, week, or even month at the helm. Take your time to discover the culture of the business, the needs of its customers, and the idiosyncrasies of its vendors before you attempt to make major changes. Employees, customers, and vendors don’t like quick change, especially when the person behind the change is new and relatively unknown. ✓ Consult the prior owner. Don’t expect to know everything there is to know about running your new business. No matter how much better a business manager you may think you are than your predecessor, he or she has certain knowledge and skills that you don’t have. Don’t let your ego stand in the way of asking the previous owner for advice. ✓ Work with a good tax advisor. You don’t want to fall behind in filing your taxes or filling out the right tax forms, or you’ll have a nasty surprise in the form of an unexpectedly large tax bill. The tax advisor who helped you with evaluating your business purchase may be able to recommend a tax advisor you can work with at least during your first year of business ownership. You also need to make sure you come out of the starting gates with well-organized and accurate financial statements. See Chapter 19 for more details. Much like a first-time home buyer’s excitement at moving into a newly purchased home, your euphoria at owning your business may quietly slip into anxiety when you realize that your work is just beginning. Relax, take deep breaths, and use the time-tested method of breaking a big task into many smaller manageable ones. Also, rest assured that if you take the advice we offer throughout Part II and you do your homework before buying your business, you should end up purchasing a company that doesn’t have major problems and that you have the skills to run well.

65 structure. Don’t make rash changes in this
area, especially if you’re thinking about reducing benefits and/or compensation. Early, negative changes can have ugly long-term consequences. ✓ Walk; don’t run. Don’t make huge changes your first day, week, or even month at the helm. Take your time to discover the culture of the business, the needs of its customers, and the idiosyncrasies of its vendors before you attempt to make major changes. Employees, customers, and vendors don’t like quick change, especially when the person behind the change is new and relatively unknown. ✓ Consult the prior owner. Don’t expect to know everything there is to know about running your new business. No matter how much better a business manager you may think you are than your predecessor, he or she has certain knowledge and skills that you don’t have. Don’t let your ego stand in the way of asking the previous owner for advice. ✓ Work with a good tax advisor. You don’t want to fall behind in filing your taxes or filling out the right tax forms, or you’ll have a nasty surprise in the form of an unexpectedly large tax bill. The tax advisor who helped you with evaluating your business purchase may be able to recommend a tax advisor you can work with at least during your first year of business ownership. You also need to make sure you come out of the starting gates with well-organized and accurate financial statements. Much like a first-time home buyer’s excitement at moving into a newly purchased home, your euphoria at owning your business may quietly slip into anxiety when you realize that your work is just beginning. Relax, take deep breaths, and use the time-tested method of breaking a big task into many smaller manageable ones. Also, rest assured that if you take the advice offerred and you do your homework before buying your business, you should end up purchasing a company that doesn’t have major problems and that you have the skills to run well.

66 One of the least-pleasant aspects of starting and running a small business
is comprehending and adhering to the myriad government regulations that affect how and where you do business. Not to mention the plethora of legal issues that can blow up in your face and culminate in a lawsuit. And if the thought of these penalties isn’t enough, we have what we hope is an incentive for you to familiarize yourself with the issues raised in this chapter: We can save you time and headaches by showing you how to efficiently and correctly complete important legal and regulatory tasks. Navigating Small-Business Laws You may think that if you’re starting or operating a truly small small business, you don’t need to know much on the legal and regulatory fronts. We wish that were true, but it’s not. Consider the following types of issues that most small-business owners must grapple with, both in the early years of their businesses and on an ongoing basis:

67 ✓ Selecting a name for your business: You can’t simply choose any name
and start using it for your business. After all, you may select a name that another business is already using, and that owner could take legal action against you. Besides, you’ll probably spend a lot of marketing money over the years to distinguish your business from the masses, and you don’t want people (especially your customers) to confuse your business with someone else’s. ✓ Complying with government licensing and permit requirements: Federal, state, and sometimes even local governments regulate and license certain types of businesses, such as restaurants, taxicabs, and beauty shops. If you’re operating a business that requires registration with particular government entities, the passing of certain exams, or the satisfaction of specific licensing requirements, you’ll be breaking the law and may be put out of business if you don’t comply. The possible penalties for running afoul of business laws can be steep and can include monetary fines and outright prohibition against practicing your line of work for months or even years. And if that isn’t bad enough, your transgressions may become public knowledge (and permanently etched into the Internet), which can hamper your ability to get your business up and running again when you’re legally able to do so. ✓ Protecting your ideas and work: If you prepare a business plan and distribute it for comment or to raise money, you don’t want anyone to steal your ideas, do you? If you invent or brainstorm something new and unique, you don’t want someone else to copy your creation and profit from it, do you? Well, if you don’t properly protect your ideas, work, and other creative developments through trademarks, copyrights, and patents, someone could rip you off and you’ll have little, if any, legal recourse. ✓ Establishing a retirement plan: Perhaps you’ve heard of retirement plans such as profit sharing, money purchase pension plans, SEP-IRAs, and so on. Over the years, these plans can slash tens, and maybe even hundreds, of thousands of dollars off your tax bill. However, if you have employees, they’re entitled to certain retirement benefits that are subject to federal regulations. Your reward for violating retirementplan rules can be the disallowance of your contributions into the plan, thereby causing you to owe the IRS taxes and penalties — ouch! ✓ Filing your taxes: As a business owner and self-employed person, you’re responsible for properly filing all federal, state, and local taxes for yourself and your business. And when you employ others, you must withhold

68 appropriate taxes from their wages and submit the withheld taxes in a
timely fashion to the various tax regulatory authorities. More than a few small businesses have failed because the owners fell behind on taxes and subsequently were buried by past-due payments. ✓ Hiring and managing employees: Employment law is a vast and growing area of the legal profession. When you hire and employ workers, you must be careful about what you say to them and how you manage and behave around them. If you’re not careful, you can face big legal bills and possible lawsuit damages, while the reputations of you and your hard-earned business are dragged through the mud during legal proceedings. ✓ Preparing contracts: In many ways, contracts make the business world go ’round. When properly prepared, contracts function as legally binding, enforceable agreements that your business makes with suppliers, employees, and others relating to the operation of your business. If you offer a contract to another person or business or seek to change the terms and conditions of an existing contract, you must first understand the legal ramifications. If you don’t understand these ramifications, at a minimum, you’ll have to deal with upset parties on the other end of the contract; in the worst cases, you could end up in court with soaring legal bills and potential lawsuits.

69 Suffering through Start-Up Regulations
Before you begin working with your first customer, you need to invest time and money into getting your legal and regulatory ducks in a row. In the start-up phase of a small business, however, few business owners have the luxury of spending hard-to-spare time and money on these issues. So in this section, we assist you in saving some of both while helping you protect your business. Complying through licensing, registrations, and permits Years ago, when Eric started his financial counseling practice, the first thing he did was investigate what government regulatory organizations he needed to register with. To his surprise, he had to register with both the federal Securities and Exchange Commission (SEC) and his state’s Department of Corporations. He was surprised because he figured that a profession as full of deception, conflicts of interest, and outright cases of corruption as the financial planning profession would’ve had less government oversight. (Then again, government “oversight” of a profession can literally result in oversights!)

70 To discover the various ways in which different government bodies regulate
your line of business, we suggest you check with the following: ✓ Trade associations for your business or profession: Most lines of business have active trade associations, whose management and members can share war stories and information about regulations. Obviously, association members in your local area will have far more relevant experiences to share, assuming they aren’t competitors. Check out the Small Business Sourcebook (a useful reference publication published by Gale), which you can probably find at your local library. ✓ Peers in your profession: Those who have been there and done that can save you time by sharing their experiences. The simplest way to network with others in your line of work is to attend conferences or conventions for your industry or profession. Again, trade associations can help you locate such events, or you can network in your local area. A downside of the local-area strategy is that people in the same line of work in your town may view you as competition and be less than forthcoming with assistance. Also, keep in mind that others may or may not have done a thorough job of researching regulatory requirements and may have chosen not to comply with certain regulations. If you’re fortunate enough to live in a community that has a business incubator, stop in and inquire about one or more of its lessees. They are, by definition, people who recently went through the same thing you’re going through now. ✓ The state agency that oversees corporations and/or small businesses: Check out the state government section in your local phone directory or peruse your state’s website to find the right number to call. Look for any of the following state government agencies: Economic Development Department, Department of Commerce, or the Office of Small Business. When you make the call, be persistent, because if the person who answers the phone is poorly trained or having a bad day, you may not get the information you need and you may have to start over again with a different department. ✓ Other relevant local government agencies: Let your fingers do the walking through the government (city, county, and federal) section of your local phone directory. For tax issues, look under Tax Collector. For real

71 Department. For health-related issues, look under Health Department.
If you get stuck and can’t reach the correct department, most cities and towns have a city clerk or town clerk who can transfer you to the right department. ✓ Trade publications: You may be surprised at how many specialized occupational publications exist. You can research past articles on industry regulations in such publications. (You may need to contact the publication for a listing of topics covered in prior issues, or you can check out the publication’s website for an internal search engine.) ✓ The local Chamber of Commerce: Most communities have a local Chamber of Commerce; the better ones have helpful information for prospective and current small-business owners (including the applicable government organizations you need to check in with and the other people you need to speak to). ✓ Small Business Development Centers (SBDCs): Every state has an SBDC, and most SBDCs have extensive small-business libraries, as well as a wide variety of pamphlets and brochures, compliments of the applicable government organizations. ✓ Experienced small-business advisors: Tax and legal advisors, as well as consultants experienced with businesses like yours, can help point you in the right direction. Although such advisors generally charge a hefty hourly fee, the advice can be well worth the price if you select a good advisor. An advisor may even be willing to offer free tips on general regulatory issues in order to cultivate your future business. ✓ Real estate agents and building contractors: If your business will operate in a commercial or retail space, you can acquire knowledge by conversing with agents who sell or lease space and/or contractors who develop and renovate space similar to what your business will occupy.

72 In the next sections, we dig deeper into the realities of compliance and the
local, state, and federal regulations you must follow. The realities of compliance Various government agencies — at the local, regional, state, and federal levels — impose all sorts of licensing, registration, and permit requirements on small-business owners. If you’ve ever arrived in a new city without a map and tried to get around by yourself in a car, you already know what it may be like as you try to discover all the agencies and paperwork required for the type of business you want to operate. If you overlook applying for one important permit or license, the government can slap you with hefty fines, and disgruntled customers can sue you, using your lack of compliance with government regulations as an indicator of slipshod business practices. And even if you’re a good enough detective to ferret out and understand the government regulations with which you must comply, you may tear out your hair trying to determine the right order in which to obtain your permits and licenses. Okay, so life could be worse — you could live in a communist country where such permits are available only to the highest bidders! Just remember to keep your eyes and ears open. Talk to as many people as you can and remember that the burden for compliance falls on your shoulders. Don’t toss your hands in the air, say that compliance with government regulations is too hard to figure out, and just wing it. The success or failure of a business often lies in the details — or, more specifically, in the owner’s willingness to pay attention to them. Complying with all applicable regulations is an early test!

73 Local regulations: Taxes, zoning, and health
The town, city, and county in which you operate your business more than likely impose some requirements on businesses like yours. Even if you operate a home-based business, you can’t assume that you can do what you want when and where you want to do it because home-based businesses often are even more restricted than their office-park counterparts. Some common local regulations that affect small-business owners include the following: ✓ Taxes: In most areas, if you’re selling products through a retail store, you have to collect sales tax. In fact, even if you don’t operate a retail store, you may have to collect sales tax on products you sell, and some cities tax all revenue from small businesses. Plus, you may be surprised to discover that some communities levy an annual property tax on certain business assets such as inventory, equipment, and furniture. ✓ Fictitious name: If the name of your business is different from your own name, you need to file what’s known as a fictitious name or doing business as (DBA) form. You usually file your DBA form through the county, and you may have to publish your DBA filing in a local newspaper. ✓ Real estate: All real estate is affected by zoning, which restricts the use of a given property. If you don’t like the idea of local government telling you what you can and can’t do on your property, consider how you’d feel if your next-door neighbor opened a chicken and pig farm on his property! Whether you’re leasing or buying a property, you’ll have to deal with zoning ordinances.

74 Local regulations: Taxes, zoning, and health
The town, city, and county in which you operate your business more than likely impose some requirements on businesses like yours. Even if you operate a home-based business, you can’t assume that you can do what you want when and where you want to do it because home-based businesses often are even more restricted than their office-park counterparts. Some common local regulations that affect small-business owners include the following: ✓ Taxes: In most areas, if you’re selling products through a retail store, you have to collect sales tax. In fact, even if you don’t operate a retail store, you may have to collect sales tax on products you sell, and some cities tax all revenue from small businesses. Plus, you may be surprised to discover that some communities levy an annual property tax on certain business assets such as inventory, equipment, and furniture. ✓ Fictitious name: If the name of your business is different from your own name, you need to file what’s known as a fictitious name or doing business as (DBA) form. You usually file your DBA form through the county, and you may have to publish your DBA filing in a local newspaper. ✓ Real estate: All real estate is affected by zoning, which restricts the use of a given property. If you don’t like the idea of local government telling you what you can and can’t do on your property, consider how you’d feel if your next-door neighbor opened a chicken and pig farm on his property! Whether you’re leasing or buying a property, you’ll have to deal with zoning ordinances.

75 given location, as well as plan on dealing with the good folks in City Hall
if you want to do any renovations to your place of business. If those renovations raise any environmental concerns — such as disturbing or removing potentially hazardous substances like asbestos — you may need to involve your local health department as well (see the next bullet). Zoning and renovation issues often come into play when a homeoffice business steadily grows and the owner finally decides to add on to his house or garage in order to hire another employee or carry more products in inventory or when the business generates a level of activity that affects noise levels, traffic, and parking demands. ✓ Health and safety: Small-business owners whose enterprises involve food are subject to all sorts of regulations from the local health department. For instance, you may need to have your water tested occasionally if you live in a less densely populated area that uses well water. And don’t overlook the myriad safety regulations, such as local fire codes and elevator inspections. State regulations: More taxes, licensing, insurance, and the environment In addition to regulations at the local level, states impose requirements on businesses, and you need to be aware of, and comply with, these requirements. Most states have established agencies to assist business owners with doing business in the state. After all, states do have some vested interest in trying to attract and retain businesses because business tax revenues fill their coffers. Here are the primary issues that may affect your small business due to state regulations: ✓ Licenses: State licensing is primarily intended to reduce the consumer’s likelihood of being fleeced or victimized. Although some occupations (such as doctors and lawyers) are universally required to be licensed, each state has a unique list of occupations that it regulates. State licensing requirements vary by occupation and by state. In some states, you can get certain licenses after you complete a few forms and pay the state a fee. In most cases, however, you have to take a test or complete some form of certification in order to get a license. ✓ Taxes: As we discuss in the local regulations section, some businesses, such as retailers, have to collect sales tax on products sold. In most states, all businesses must pay income taxes at the state level

76 employee-related insurance will feel like another tax
employee-related insurance will feel like another tax. Common staterequired coverage includes workers’ compensation, which compensates workers for lost wages due to job-related injuries, and unemployment insurance, which pays laid-off employees for a certain period of time or until they secure another job. ✓ Environment: If you’re a manufacturer and your plant emits unsavory smoke, particles, or odors into the air or water, you can be certain that your state (and possibly other government agencies) will regulate your activities — and for good reason. Left to their own devices, some unsavory business owners would knowingly pollute because installing control devices would add to the cost of doing business, effectively reducing profits. Federal regulations: Still more taxes, licenses, and requirements In addition to local and state regulations, small-business owners must comply with U.S. federal government regulations, which cover taxes and licenses as well as the health, safety, and welfare of your employees. Not all federal labor laws affect all small businesses because some issues apply only to employers with a specific number of employees. So the good news may be that your small business is small enough that you don’t have to concern yourself with all the issues we cover in the following list. (Find out what issues apply to your business by consulting the resources listed in the section “Complying through licensing, registrations, and permits.”) Here are the key federal regulations most small-business owners need to consider: ✓ Licenses: Most businesses that require a license or permit to operate generally obtain the documentation at the state level. Some businesses, however, receive permits and licenses at the federal level. These businesses include alcohol and tobacco manufacturers, drug companies, firearm manufacturers and dealers, investment advisors, meat packing and preparation companies, radio and television stations, and trucking and other transportation companies. ✓ Taxes: All incorporated businesses, or their owners if the business isn’t incorporated, must file a federal income tax return. Additionally, most small-business owners — especially those who hire employees — choose to apply for and utilize a federal Employer Identification Number (EIN). ✓ Americans with Disabilities Act (ADA): This legislation prohibits employers with 15 or more employees from discriminating against prospective and current employees or customers with disabilities. Such

77 discrimination is barred in the hiring, management, and dismissal of any
employee. For example, during the process of interviewing job applicants, you can get yourself into a heap of legal hot water if you exclude from consideration qualified candidates who are in some way disabled. ✓ Family and Medical Leave Act: This legislation requires employers with 50 or more employees (within 75 miles) to provide up to 12 weeks of unpaid leave to employees who desire or need the leave for personal health issues due to a serious medical condition that affects the employee’s ability to perform the regular duties of his or her job; to spend time with a newborn or adopted child; or to care for a family member who has a serious medical condition. During the term of an employee’s leave, the employer must continue to cover the employee under the company’s group health-insurance plan under the same conditions as when the employee was working. Eligible employees (who have been with the employer for at least one year and who have worked at least 125 hours over the previous year) who take a leave under the Family and Medical Leave Act generally can do so with the understanding that they can return to their same positions with the same pay and benefits. So-called highly paid “key” employees aren’t guaranteed the same positions and compensation packages if their returns would lead to significant economic harm to the employers. (The Department of Labor defines a key employee as a salaried employee “. . . who is among the highest paid 10 percent of employees within 75 miles of the work site.”) ✓ 2010 federal health-insurance legislation: Congress passed sweeping health-insurance legislation in 2010 that affects and will affect many small businesses. Selection of a business entity In the start-up phase of your business, be sure to consult your attorney or tax advisor about what type of organization or business entity — for example, sole proprietorship, partnership, corporation, or limited liability company (LLC) — makes sense for your enterprise. Although the different corporate entities that you may form for your business can provide some legal protection for you and your personal assets, establishing such entities involves significant time and expense and doesn’t completely insulate you and your company from lawsuits. Given the excitement and stresses inherent in the early days of running a small business, we can understand why you may not care to spend your precious time and money on researching and consulting with legal and tax experts about what type of organization you should establish.

78 Protecting ideas: Nondisclosures, patents,
trademarks, and copyrights Your business idea and business plans probably aren’t 100 percent unique. Some business owners, however, have taken a different twist on something or have created a truly unique product or service. But even if you don’t have a unique or different product or service to offer, you don’t want others to steal your plans and ideas. By circulating copies of your business plan , you may be giving away much of your hard work and ideas to an individual or another business that can end up being a competitor. The following sections explain what you need to know about protecting your business and ideas in general and specifically through nondisclosures, trademarks, patents, and copyrights. General tips for protecting your ideas Here are some tips for how to protect your business plan and ideas: ✓ Be careful about who sees your business plan. A friend or advisor who happens to know a lot about your type of small business, or small businesses in general, is unlikely to have unfriendly motives in looking at your plan. On the other hand, an industry insider or a potential competitor who peruses your plans may not have your best interests at heart. ✓ Keep proprietary information out of your plan. Don’t include product designs, manufacturing specifications, unique resources, or other information unique to your company in the copies of your business plan that you distribute to others. Share such information with serious investors only if needed to gain their investments, and do so with a nondisclosure agreement attached (see the next section). ✓ Place a nondisclosure statement in the front of your business plan. If your plan does fall into the hands of someone who may be inclined to steal your ideas, a nondisclosure statement (which we discuss in the next section) should scare them off. ✓ Get legal assistance when necessary. If your work and ideas are proprietary and protectable, speak with an attorney who specializes in intellectual property, including copyrights, trademarks, and patents. We explain these important legal protections in the upcoming section “Patents, trademarks, and copyrights.” Nondisclosure agreements (NDAs) Always be sure to attach a nondisclosure agreement (NDA) to the beginning of your business plan before you circulate it for review. The purpose of the NDA is to warn the reader that the enclosed contents are private property and

79 attorney to craft this agreement.)
are not to be spread around without your consent. (Note: You don’t need an attorney to craft this agreement.) Simply including the NDA with your business plan isn’t enough; never hand out your plan without first having the recipient sign the NDA. Following is a sample nondisclosure agreement: This confidential Business Plan has been prepared in order to raise financing for Wowza Widgets, Inc. This material is being delivered to a select number of potential investors, each of whom agrees to the following terms and conditions: Each recipient of this Business Plan agrees that, by accepting this material, he or she will not copy, reproduce, distribute, or discuss with others any part of this plan without prior written consent of Wowza Widgets, Inc. The recipient agrees to keep confidential all information contained herein and not use it for any purpose whatsoever other than to evaluate and determine interest in providing financing described herein. This material contains proprietary and confidential information regarding Wowza Widgets, Inc., and is based upon information provided to Wowza Widgets, Inc., by sources deemed to be reliable. Although the information contained herein is believed to be accurate, Wowza Widgets, Inc., expressly disclaims all liability for any information, projections, or representations (expressed or implied) contained herein from omissions from this material or for any written or oral communication transmitted to any party in the course of its evaluation for this financing. The recipient acknowledges that this material shall remain the property of Wowza Widgets, Inc., and Wowza Widgets, Inc., reserves the right to request the return of the material at any time and in any respect, to amend or terminate solicitation procedures, to terminate discussions with any and all prospective financing sources, to reject any and all proposals, or to negotiate with any party with respect to the financing of Wowza Widgets, Inc. The projections contained in the pro-forma Financial Section are based upon numerous assumptions. Although Wowza Widgets, Inc., believes that these assumptions are reasonable, no assurance can be given as to the accuracy of these projections because they are dependent in large part upon unforeseeable factors and events. As a result, the actual results achieved may vary from the projections, and such variation can be material and adverse. Signature (print): __________________________________________________ Signature: _________________________________________________________

80 Patents, trademarks, and copyrights
You may have created a product, service, or technology unique enough that you want to prevent others from copying it. Or maybe you simply want to restrain others from using and profiting from the name of your business or literary, musical, or artistic creations. Welcome to the wonderful and often confusing world of patent, copyright, and trademark law. You’ll be relieved to hear that this isn’t a legal book, in part because your two humble authors are, happily (for us at least), not lawyers. And most small-business owners don’t need to spend much time or legal expense on these issues. If you do need to deal with patents, copyrights, or trademarks, you have to be familiar with the following very important terms. For more information, consult a lawyer who specializes in intellectual property. ✓ Patent: If you’ve invented something (such as a new type of toy or computer disk), you may want to explore patenting your invention. The reason: By filing a patent with the federal government, you have exclusive rights to manufacture, sell, and use the patented invention. You can, if you so choose, license usage of the patent to others. ✓ Trademark: Companies invest significant time, effort, and money into creating brand names (for example, Coca-Cola and For Dummies), marketing strategies, advertising slogans (Making Everything Easier!), logos (the Dummies Man on this book’s cover or the Nike swoosh, for instance), and so on. The point of the trademark is to protect your brands and prevent other enterprises from using and profiting from the recognition and reputation you’ve developed through your business’s brand names, marketing/advertising images, and the words associated with your product. Trademarked items can also include things such as the packaging, shape, character names, color, and smell associated with a product. If you think your business has identifying characteristics that you don’t want copied by competitors, think about applying for trademark protection. Note: Patents and trademarks are handled by the U.S. Patent and Trademark Office ( copyrights are the domain of the U.S. Copyright Office ( ✓ Copyright: Copyright laws cover such works as musical and sound recordings, literary works, software, graphics, and audiovisuals. The owner of the copyright of a work is solely allowed to sell the work, make copies of it, create derivations from it, and perform and display the work. The creator of the work isn’t always the person or part of the organization that holds the copyright, though. For example, writers sometimes do freelance writing for publications that hold the copyright to the work that their writers create for them.

81 authorship yourself to save money. A two-page form is available from
the U.S. Copyright Office ( ). Follow the directions and you can register your copyright yourself. You must pay a modest filing fee for each request, but you can put similar works on one form. No copyright cops are out there searching for people who are violating your patents, trademarks, or copyrights. The burden is on you to perform the detective work yourself; if you detect a violation, head immediately for an attorney. A business prenup: Contracts with customers and suppliers All small businesses have customers as well as suppliers (or vendors). In both of these relationships, small-business owners often engage in contracts, whether formally written or verbal. Here are our tips for dealing with contracts with your customers and suppliers: ✓ Get it in writing. Otherwise, you have little or no recourse if someone (such as a supplier) doesn’t deliver as promised. ✓ Don’t make promises verbally that you aren’t willing to put into writing. What you say can get you into trouble, especially in terms of your customers and advertising. ✓ Get a legal perspective. You need to seek legal assistance for small-business operation issues at various times in the life of your business. When you’re drafting contracts is one of those times. Whether or not you should develop a contract with a vendor or a customer depends on the situation. If, for example, you’re working with a local customer or vendor — especially someone you know — and you think he may be offended by your request for a formal contract, sticking with handshakes is fine. If, however, you happen to land a whale for a customer or you order products from a large vendor, neither of whom you have a personal relationship with, you should definitely initiate a formal contract. In fact, most large companies — whether they’re customers or vendors — expect a formal contract as part of the package. If they don’t get one, they may wonder about your ability to work with them on a professional level. If the professionalism issue isn’t enough to convince you to develop a formal

82 contract, let self-preservation be your motivator
contract, let self-preservation be your motivator. After all, large businesses don’t always have small businesses’ best interests in mind. Why not lock in your safety with a contract? Laboring over Employee Costs and Laws When your business begins to hire employees, the good news is that it has probably gotten off the ground sufficiently well enough to afford the costs associated with hiring and managing them. The bad news is that, besides the salary you pay your employees, you’ll encounter several significant “hidden” costs, including the following ✓ Taxes: On top of your employees’ salaries, you’re also responsible for paying Social Security taxes on their earnings, as well as other taxes, such as unemployment insurance. When hiring, you must be careful about whether you hire people as employees or independent contractors. Many small-business employers prefer to hire people as independent contractors because doing so lowers their tax bills, but the IRS has strict rules for who qualifies as an independent contractor. If you classify someone as a contractor who should be considered an employee, you could end up facing stiff penalties. ✓ Employee benefits: Various insurance programs, paid vacation, and retirement plans help attract and retain employees. The smallest small businesses can’t afford to offer many employee benefits, but you should know your options and be aware of what your competition is offering. ✓ Government regulations: Are you surprised that a host of local, state, and federal government regulations dictate, mandate, and cajole your hiring, management, and dismissal of employees? You shouldn’t be if you’ve read this chapter all the way through! ✓ Employee lawsuits: Don’t think that just because you’re not running a billion-dollar enterprise you can’t and won’t be sued. Although some employee suits are frivolous, others are caused by employers not exercising proper care when dealing with employees. .

83 Mastering Small-Business Taxes
▶ Managing your business taxes and maintaining sound financial records ▶ Identifying and managing your tax bracket ▶ Understanding employee tax issues ▶ Using sensible tax write-offs ▶ Choosing a tax-friendly corporate entity

84 WELFARE SYSTEM The U.S. social welfare structure has been shaped both by long standing traditions and by changing economic and social conditions. In its early history, the United States was an expanding country with a vast frontier and a predominantly agricultural economy. Up to 1870, more than half the Nation’s adult workers were farmers. In the years that followed, however, industry developed rapidly and the economy tended increasingly to be characterized by industrialization, specialization, and urbanization. The result was a Nation of more employees who were dependent on a continuing flow of money income to provide for themselves and their families. From the earliest colonial times, local villages and towns recognized an obligation to aid the needy when family effort and assistance provided by neighbors and friends were not sufficient. This aid was carried out through the poor relief system and almshouses or workhouses. Gradually, measures were adopted to provide aid on a more organized basis, usually through cash allowances to certain categories among the poor. Mothers’ pension laws, which made it possible for children without paternal support to live at home with their mothers rather than in institutions or foster homes, were adopted in a number of States even before World War I. In the mid-twenties, a few States began to experiment with old-age assistance and aid to the blind. Meanwhile, both the States and the Federal Government had begun to recognize that certain risks in an increasingly industrialized economy could best be met through a social insurance approach to public welfare. That is, the contributory financing of social insurance programs would ensure that protection was available as a matter of right as contrasted with a public assistance approach whereby only those persons in need would be eligible for benefits. In the United States, as in most industrial countries, social insurance first began with workers’ compensation. A Federal law covering civilian employees of the Government in hazardous jobs was adopted in 1908, and the first State compensation law to be held constitutional was enacted in By 1929, workers’ compensation laws were in effect in all but four States. These laws made industry responsible for the costs of compensating workers

85 or their survivors when the worker was injured or killed in connec
tion with his or her job. Retirement programs for certain groups of State and local government employees—mainly teachers, police officers, and fire fighters—date back to the 19th century. The teachers’ pension plan of New Jersey, which was established in 1896, is probably the oldest retirement plan for government employees. By the early 1900’s, a number of municipalities and local governments had set up retirement plans for police officers and fire fighters. New York State and New York City set up retirement systems for their employees in 1920—the same year that the Civil Service Retirement System was set up for Federal employees. Another area where the Federal Government accepted an early responsibility was in the provision of benefits and services for persons who served in the Armed Forces. These veterans’ benefits at first consisted mainly of compensation for the war-disabled, widows’ pensions, and land grants. Later, emphasis was placed on service pensions and domiciliary care. Following World War I, provisions were made for a full-scale system of hospital and medi cal care benefits.

86 The development of social welfare programs has been strongly pragmatic and incremental. Proposals for change are generally formulated in response to specific problems rather than to a broad national agenda. A second characteristic of U.S. social welfare policy development is its considerable degree of decentralization. Some programs are almost entirely Federal with respect to administration, financing, or both; others involve only the States (with or without participation of local government); still others involve all three levels of government. The important role played by the private sector is another aspect of decentralization in the development of American social welfare programs. The private sector shares a large role in the provision of health and medical care and income maintenance benefits in the form of employment related pensions, group life insurance, and sickness payments. The severe Depression of the 1930’s made Federal action a necessity, as neither the States and the local communities nor private charities had the financial resources to cope with the growing need among the American people. Beginning in 1932, the Federal Government first made loans, then grants, to States to pay for direct relief and work relief. After that, special Federal emergency relief and public works programs were started. In 1935, President Franklin D. Roosevelt proposed to Congress economic security legislation embodying the recommendations of a specially created Committee on Economic Security. There followed the passage of the Social Security Act, signed into law August 14, 1935.

87 Social Security Act Title I Title II Title III Title IV Title V Title VI Title VII Title VIII Title IX Title X Title XI Grants to States for Old-Age Assistance Federal Old-Age Benefits Grants to States for Unemployment Compensation Administration Grants to States for Aid to Dependent Children Grants to States for Maternal and Child Welfare Public Health Work Social Security Board Taxes with Respect to Employment (for Old-Age Insurance) Tax on Employers of Eight or More (for administration of unemployment compensation) Grants to States for Aid to the Blind General Provisions

88 This law established two social insurance programs on a national scale to help meet the risks of old age and unemployment: a Federal system of old-age benefits for retired workers who had been employed in industry and commerce, and a Federal-State system of unemployment insurance. The choice of old age and unemployment as the risks to be covered by social insurance was a natural development, since the Depression had wiped out much of the lifetime savings of the aged and reduced opportunities for gainful employment. The Act also provided Federal grants-in-aid to the States for the means-tested programs of Old-Age Assistance, and Aid to the Blind. These programs supplemented the incomes of persons who were either ineligible for Social Security (Old-Age and Survivors Insurance) or whose benefits could not provide a basic living. The intent of Federal participation was to encourage States to adopt such programs. The law established other Federal grants to enable States to extend and strengthen maternal and child health and welfare services, and these grants became the Aid to Families with Dependent Children program, which has been replaced in 1996 with a new block grant program for Temporary Assistance for Needy Families. (The Act also provided Federal grants to States for public health services and services of vocational rehabilitation. Provisions for these grants were later removed from the Social Security Act and incorporated into other legislation.) The Old-Age Insurance program was not actually in full operation before significant changes were adopted.

89 In 1939, Congress made the Old-Age Insurance system a family program\ when it added benefits for dependents of retired workers and surviving dependents of deceased workers. Benefits also became first payable in 1940, instead of 1942 as originally planned. No major changes were made again in the program until the 1950’s, when it was broadened to cover many jobs that previously had been excluded—in some cases because experience was needed to work out procedures for reporting the earnings and collecting the taxes of persons in certain occupational groups. The scope of the basic national social insurance system was significantly broadened in 1956 through the addition of Disability Insurance. Benefits were provided for severely disabled workers aged 50 or older and for adult disabled children of deceased or retired workers. In 1958, the Social Security Act was further amended to provide benefits for dependents of disabled workers similar to those already provided for dependents of retired workers. In 1960, the age-50 requirement for disabled-worker benefits was removed. The 1967 amendments provided disability benefits for widows and widowers aged 50 or older.

90 The 1972 amendments provided for automatic cost-of-living increases in benefits tied to increases in the Consumer Price Index (CPI), and created the delayed retirement credit, which increased benefits for workers who retire after the normal retirement age (currently age 65). The 1977 amendments changed the method of benefit compu tation to ensure stable replacement rates over time. Earnings included in the computation were to be indexed to account for changes in the economy from the time they were earned. The 1983 amendments made coverage compulsory for Federal civilian employees and for employees of nonprofit organizations. State and local governments were prohibited from opting out of the system. The amendments also provided for gradual increases in the age of eligibility for full retirement benefits from 65 to 67, beginning with persons who attain age 62 in the year For certain higher income beneficiaries, benefits became subject to income tax. The amendments in 1994 raised the threshold for coverage of domestic workers’ earnings from $50 per calendar quarter to $1,000 per calendar year (with $100 amount increments after 1995, as average wages rise).

91 By the 1930’s, private industrial pension plans were far more
Changes developed in the rail industry than in most other businesses or industries; but these plans had serious defects that were magnified by the Great Depression. While the Social Security system was in the planning stage, railroad workers sought a separate railroad retirement system that would continue and broaden the existing railroad programs under a uniform national plan. The proposed Social Security system was not scheduled to begin monthly benefit payments for several years and would not give credit for service performed prior to 1937, while conditions in the railroad industry called for immediate benefit payments based on prior service. Legislation was enacted in 1934, 1935, and 1937 to establish a railroad retirement system separate from the Social Security program legislated in While the railroad retirement system has remained separate from the Social Security system, the two systems are closely coordinated with regard to earnings credits, benefit payments, and taxes. The railroad unemployment insurance was also established in the 1930’s. Other programs also made advances in the period since In 1948, the last of the States adopted a workers’ compensation program. The laws relating to work-connected accidents gradually improved the provisions for medical benefits and rehabilitation extension services. During the 1940’s, four States adopted legislation providing weekly cash sickness benefits to workers who are temporarily disabled because of nonoccupational illness or injury. For Federal civilian employees, programs were enacted providing group life insurance in 1954 and health insurance benefits in Since then, an increasing number of State and local government jurisdictions initiated retirement programs for their employees. At present more than 75% of all State

92 and local employees are covered both by the basic national OASDI program and by a supplementary State or local system. As a result of World War II and the Korean conflict, special veterans’ legislation was enacted, with primary emphasis on assisting ex-servicepersons to adjust from military to civilian life. Not only were the older compensation and pension benefits available to World War I veterans carried forward, but veterans were provided vocational rehabilitation, unemployment allowances, educational and training benefits, and job placement services. One of the most important pieces of social legislation was the establishment of the Medicare program under the Social Security Amendments of The program provided for the medical needs of persons aged 65 or older, regardless of income. The 1965 legislation also created Medicaid (Federal grants to States for Medical Assistance Programs). Medicaid provides medical assistance for persons with low incomes and resources. It replaced the former programs of medical vendor payments to public assistance recipients and medical assistance for medically needy persons aged 65 or older. Both Medicare and Medicaid have been subject to numerous legislative changes since 1965. The public assistance provisions of the Social Security Act were also broadened. In 1972, the State-administered cash

93 assistance programs for the aged, blind, and disabled were replaced by the essentially federally administered Supplemental Security Income (SSI) program. Other assistance programs not included in the Social Security Act were also broadened or new ones added. The Food Stamp program was enacted in 1964 to improve the nutrition of low-income families. Other nutrition programs include the Special Supplemental Food Program for Women, Infants, and Children (WIC) and school breakfasts and lunches. In addition, Federal-State programs provide home energy assistance, and public and subsidized housing. The Personal Responsibility and Work Opportunity Reconciliation Act of 1996 (Public Law ) resulted in significant changes to public assistance programs. The Aid to Families with Dependent Children program has been replaced by block grants to the States for Temporary Assistance for Needy Families. The legislation also has substantial implications for the SSI and Medicaid programs, which is explained in the individual program sections. Although there is no system of family allowances in the United States, workers with dependent children are given deductions in the computation of their Federal income tax liability, and the working poor receive an additional reduction in their tax liability. Free public education is available to all children through secondary schools.

94 Development of U.S. Social Security Programs Programs
1935 Social Security Old-Age Insurance; Unemployment Insurance; and Public Assistance programs for needy aged, and blind (replaced by the SSI program in 1972); and Aid to Families with Dependent Children (replaced with block grants for Temporary Assistance for Needy Families in ) 1934 Railroad Retirement System 1937 Public Housing 1939 Social Security Old-Age and Survivors Insurance 1946 Natonal School Lunch Program 1950 Aid to the Permanently and Totally Disabled (replaced by the SSI program in 1972) 1956 Social Security Disability Insurance 1960 Medical Assistance for the Aged (replaced by Medicaid in 1965) 1964 Food Stamp Program 1965 Medicare and Medicaid Programs 1966 School Breakfast Program 1969 Black Lung Benefits Program 1972 Supplemental Security Income Program 1974 Special Supplemental Food Program for Women, Infants, and Children (WIC) 1975 Earned Income Tax Credit 1981 Low-Income Home Energy Assistance 1996 Temporary Assistance for Needy Families

95 The Minsky Theory of Financial Crises
In a series of works published in the 1980s and early 1990s, Hyman Minsky developed an important theory of financial crises.1 This theory helps us understand the forces that create financial crises and explains why these crises occur with such regularity. Minsky spent most of his career at academic institutions such as Brown, Berkeley, and Washington University in St. Louis. He died in Perhaps because the United States and other highly developed nations experienced an 16 The Financial Crisis and Federal Reserve Policy unusual period of sustained economic stability in the quarter century extending from the severe 1981–1982 worldwide recession through the mid- 2000s, Minsky’s work received relatively little attention during his lifetime. However, because his theory of financial crises turned out to be remarkably prescient in accounting for the unfolding of the chain of events of 2007–2009 throughout the world, Minsky’s work is now widely admired and increasingly cited by economists. Minsky argued that capitalism contains a critical flaw: recurring financial crises and economic instability are inherent characteristics of the system. He believed that the nature of banking and financial institutions, in becoming increasingly interdependent over time, would inevitably lead to major crises that wreak havoc on the nation’s overall economy. In Minsky’s framework, the supply of credit plays the central role in accounting for financial crises.

96 Minsky’s key hypothesis is that over periods of sustained prosperity,
the financial system gradually transitions from financial relationships that are consistent with a stable system to those that lead to financial instability. Over a lengthy period of good times, a financial structure dominated by conservative hedge finance inevitably gives way to the one in which speculative and Ponzi finance play ever- larger roles. This makes the system increasingly unstable and fragile. A crisis becomes an accident waiting to happen. For example, if the central bank raises interest rates during an economic boom in an attempt to reduce inflation in the presence of significant elements of speculative and Ponzi finance, assets 20 The Financial Crisis and Federal Reserve Policy must be liquidated in order to meet the higher interest obligations. Many of those initially practicing speculative finance will be forced into Ponzi status, and those already in Ponzi status will almost surely be forced to liquidate assets financed by the loans. This is likely to result in a chain reaction of falling prices of stocks, bonds, and real estate, with associated rising debt defaults and bank failures. In essence, Minsky argues that long periods of economic stability inevitably lead to episodes of serious instability. This results from the human psychological propensity to exhibit herding behavior, in which people buy a particular asset not because of its fundamental value, but simply because others are purchasing it. Because such behavior is inconsistent with the tenets of rational expectations, the predominant assumption of macroeconomic analysis since the “rational expectations revolution” of the 1970s, Minsky’s theory did not accord with contemporary economic analysis during his lifetime. Once again, however, because of its prescience in accounting for the recent worldwide crisis that commenced in 2007, the theory has gained increasing attention and respect.

The nineteenth century was a time of periodic systemic banking panics in the United States. Major panics occurred in 1819, 1837, 1857, 1873, 1884, and 1893—an average of about one serious crisis every 17 years.1 The panic of 1907 bears a strong resemblance to the earlier panics. It is of great historical significance because it led directly to the creation of the Federal Reserve System, the central bank of the United States. On December 22, 1913, Episodic booms and busts characterized nineteenth century U.S. economic history. Typically, real estate prices would increase rapidly during periods when the building of canals, expansion of railroads, or growth of cities created surging demand for land. Credit would expand rapidly in such periods of prosperity as economic fundamentals and irrational exuberance joined forces to occasionally inflate real estate and stock prices to astounding levels. Real estate and stocks typically served as collateral for bank loans, and rising prices of these assets facilitated expansion of credit during the booms.

98 After a period of extraordinary increases in asset prices, an event
would occur that would pierce the bubble. In a typical case, this might involve a rumor of an impending insolvency of a famous speculator, bank, or brokerage house. Land and stock prices would then begin to fall as speculators unloaded assets in an attempt to preserve their profits. As the existing value of collateral declined below the amount of a bank loan, the bank would ask the borrower for additional collateral. Inability to supply the necessary collateral typically led to default on the loan. Increasing loan defaults led to bank failures and panics in the form of runs on suspect banks.

99 The most severe nineteenth century crises occurred in 1873
and These crises were followed by a period of depression characterized by increasing bankruptcies, rising unemployment, bank failures, and credit stringency as debt deflation was set in motion. The early years of the twentieth century were times of rising prosperity. Having recovered from the severe panic and accompanying depression of 1893, the U.S. economy was again booming by the early 1900s. But signs of trouble began to emerge in 1905 and 1906, and by the summer of 1907 the economy was again in a precarious condition. The National Bureau of Economic Research later determined that a recession had begun in May. The stock market began falling in March and the shares of Union Pacific Railroad, widely used as collateral for loans, declined sharply. New York City teetered on the brink of bankruptcy and an offering of new bonds by the city in June failed to attract buyers.2 The copper market collapsed in July, and in August it was announced that Standard Oil had been fined the enormous sum of $29 million for violation of antitrust regulations. U.S. stocks were down sharply and banking runs had recently occurred in Germany, Japan, and Egypt.

100 Trust Companies and Banks
Prior to the Civil War, all of the nation’s banks received their operating charters from the individual states. The National Banking Act of 1863 authorized the chartering of banks by the federal government, thus establishing the dual banking system. The banks chartered by the federal government were known as national banks and were subject to regulations specified in the Banking Act. Banks chartered by individual states were governed by state banking regulations. In the absence of a central bank, organizations known as clearinghouses were formed in large cities like New York. These organizations were established by groups of individual banks that joined forces to pool resources to guarantee bank deposits and lend cash when needed to sound banks that were members of the clearinghouse. The clearinghouses served to modestly reduce the propensity of local banking panics to become systemic.

101 In New York, organizations known as trusts grew rapidly during the
decade preceding the panic of Trusts were initially established to manage the estates of very wealthy clients in the gilded age. Originally conservatively managed, they were thought to be safe and were therefore subject to fewer restraints on permissible activities than regular banks. They were less constrained in the types of assets they could purchase and were not subject to significant reserve requirements. This meant trusts could invest a larger portion of their deposits in earning assets than banks. Being subject to less stringent regulation, they could also purchase riskier assets. Trusts were more profitable and paid a higher rate of return to depositors than banks. As economic activity again became robust and memories of the banking panic and depression of 1893 dimmed, these trusts began to make riskier investments. They earned handsome returns in the early years of the twentieth century. Taking note of the superior returns, depositors began flocking to these trusts, spurring their growth. In the period from 1895 to 1907, total assets of trusts in New York expanded more than twice as rapidly as those of New York banks and reached approximate parity with these banks by As suggested by Minsky’s hypothesis, periods of rising prosperity tend to lead to overconfidence on the part of both borrowers and lenders. This was manifest in increasingly risky behavior by the New York trust institutions. As economic activity boomed in the early 1900s, these trusts began speculating in the stock market and real estate ventures. At first, returns were phenomenal. Then conditions changed for the worse. The Panic of 1907, which originated in the New York trusts, soon threatened to spread throughout the nation’s banking system.

102 In the spring of 1906, Fritz A. Heinze arrived in New York City from
the West. Heinze was a high- rolling speculator who had amassed a fortune in the copper mining business in Butte, Montana. Upon arriving in New York, Heinze joined forces with Charles Morse, a banker whose reputation—like Heinze’s—was l ess than impeccable. T ogether, t hey became affiliated with numerous banks, trusts, and insurance companies, gaining control of several and serving on the board of directors of many others. Heinze owned a great number of shares in the struggling United Copper Company back in Montana. Discovering that speculators had heavily shorted stock in United Copper—that is, had borrowed shares and sold them with the intention of repurchasing them later at a lower price, Heinze and his brother devised a scheme to enhance their personal fortunes by executing a short squeeze on the speculators. In this plan, the brothers would drive up the price of United Copper through massive purchases of the shares, using funds borrowed from banks with which they had connections. They hoped to force the short sellers to cover by repurchasing shares, most of them from the Heinzes, at much higher prices. If the scheme worked, the Heinze brothers would bankrupt the short sellers and enrich themselves.

103 Heinze had previously established a banking relationship with
Charles Barney, president of the Knickerbocker Trust Company, one of New York’s largest and most respected trust organizations. Although Barney had financed previously successful speculations by F.A. Heinze, he turned down the brothers’ request for a large loan. The undaunted Heinze brothers went ahead with the short squeeze, using personal funds and funds borrowed from other banks with whom they had close connections. In mid- October of 1907, they began purchasing shares of United Copper, pushing the price up sharply. But the brothers had misjudged the market. Those who had shorted the stock had already obtained shares to cover their short sales at prices sharply below the elevated prices resulting from the Heinze brothers’ purchases. Within two days, the price of United Copper declined by more than 80 percent and the Heinze brothers suffered huge losses.

104 At the time, the State Savings Bank of Butte, owned by Heinze, was
holding a large amount of collateral in the form of shares of United Copper posted by those to whom the bank had granted loans. When the shares crashed, the bank demanded additional collateral, which the borrowers were unable to provide. As a result, the loans went bad and the bank was declared insolvent. News about its demise triggered a massive run on Mercantile National Bank in New York, recently acquired by Heinze, which had a correspondent relationship with the Butte bank. In addition to attacking Heinze’s banks, depositors withdrew a large amount of funds from trusts and banks owned by Morse, Heinze’s partner. The State Savings Bank of Butte was just one of many smaller banks throughout the nation that had established correspondent relationships with larger city banks, many of them located in New York. In these relationships, the small banks held deposits in large banks in New York and other cities in return for services provided by the city banks. When news of the panic in New York spread, many of these smaller banks withdrew their funds from New York banks. In the scramble for liquidity, several banks and trust companies, including many of those affiliated with Morse and Heinze, were subject to runs and forced to close. In an effort to prevent a systemic panic in the larger banking system, the New York Clearinghouse forced the resignations of Heinze and Morse from banking boards in New York. This served to forestall panic for a short time.

105 However, people became increasingly concerned about known and
rumored links between notorious speculators, brokerage houses, and trusts and banks. Banking is based on confidence, which was starting to break down. On Friday, October 18, rumors spread that Charles Barney had been involved in the Heinze brothers’ disastrous attempt to corner the short sellers in United Copper. This triggered a sustained run on Barney’s Knickerbocker Trust Corporation, which was forced to close on October 22. The following day, the run spread to the Trust Company of America, the nation’s second largest trust. It is likely no coincidence that Barney was a prominent member of its board of directors.

106 However, people became increasingly concerned about known and
rumored links between notorious speculators, brokerage houses, and trusts and banks. Banking is based on confidence, which was starting to break down. On Friday, October 18, rumors spread that Charles Barney had been involved in the Heinze brothers’ disastrous attempt to corner the short sellers in United Copper. This triggered a sustained run on Barney’s Knickerbocker Trust Corporation, which was forced to close on October 22. The following day, the run spread to the Trust Company of America, the nation’s second largest trust. It is likely no coincidence that Barney was a prominent member of its board of directors.

107 John Pierpont Morgan was the principal owner of the U.S. Steel
Corporation and the most respected, knowledgeable, and wealthy banker in New York. He had no direct financial interest in the trust companies. But he realized that this growing panic had the potential to bring about a disastrous systemic crash and massive depression if it were allowed to spread to the larger banking system. The key l ink involved call loans that trusts had made to stockbrokers. Such loans can be called in at the discretion of the lender. Morgan anticipated that continued runs on the trusts would force a large- scale recall of such loans, which would trigger forced sales of shares of stock. As the decline in stock prices began to push the value of collateral below the amount of the loan, banks would systematically call in the loans, forcing brokers to dump stock, even at fire sale prices, to repay the loans. This, in turn, would create a selfperpetuating cycle of falling bank capital, bank failures, additional runs on banks, and more loan liquidation, credit tightening, and falling asset prices. The final outcome would likely be a major depression.

108 Reckoning that failure of the Trust Company could ignite a disastrous
nationwide banking panic, Morgan convened several of the city’s top bankers in a series of late- night meetings in his home. Essentially, the healthy banks were asked to ante up millions of dollars to shore up the Trust Company of America and other trusts and banks that appeared vulnerable to imminent runs. Morgan agreed to put in $25 million of his personal funds, and John D. Rockefeller volunteered to put in up to $40 million if needed. The U.S. Treasury came up with $25 million, and other large banks also contributed to the effort. On October 24, Wall Street observers noted workers carrying bags of gold and paper currency from the U.S. Treasury’s New York facility to the trusts and banks designated for help. The word spread and public psychology quickly changed. It turned out that the effort spearheaded by Morgan was sufficient to carry the day. While there remained a few bumps and challenges, the Panic of 1907 ended in early November. It had lasted only 6 weeks, and while two dozen trusts had failed, only a handful of banks had closed down.

109 T he p anic c ontributed appreciably t o the recession that e xtended
from May 1907 to June In this period, national output declined by about 10 percent and the nation’s unemployment rate increased from 3 to 8 percent. But things would have been far worse had it not been for J.P. Morgan’s wisdom and forceful leadership. Morgan, together with a few banking colleagues and Treasury officials, had essentially performed the most fundamental role of a central bank—serving as a lender of last resort to the financial system in times of panic. However, it was apparent to thoughtful observers that it would be foolish for the young nation to continue to rely on the wisdom and benevolence of a single individual for its economic health, especially when that individual may not be entirely free of conflicts of interest. Clearly, the time was at hand to establish a central bank.

110 T he p anic c ontributed appreciably t o the recession that e xtended
from May 1907 to June In this period, national output declined by about 10 percent and the nation’s unemployment rate increased from 3 to 8 percent. But things would have been far worse had it not been for J.P. Morgan’s wisdom and forceful leadership. Morgan, together with a few banking colleagues and Treasury officials, had essentially performed the most fundamental role of a central bank—serving as a lender of last resort to thul observers that it would be foolish for the young nation to continue to rely on the wisdom and benevolence of a single individual for its economic hee financial system in times of panic. However, it was apparent to thoughtfalth, especially when that individual may not be entirely free of conflicts of interest. Clearly, the time was at hand to establish a central bank. Congress passed the Federal Reserve Act. President Woodrow Wilson signed the legislation the same day. After more than 135 years in existence, the United States now had a permanent central bank. However, as the nation learned fewer than 20 years later, creation of the new central bank by no means put an end to severe banking crises. Indeed, the most severe financial crisis in U.S. history was to occur during 1929–1933.

111 HEALTH INSURANCE Sometimes it seems as if there could be nothing mo catastrophic than losing a home or a family heirloom, but there is. Keeping yourself and your loved ones safe and healthy is the most important thing in the world. Yet serious illnesses, injuries, and even death occur to everyone at some point. The only thing worse than having a serious health problem is having it without the proper insurance coverage in place. If you suffer an injury and you aren’t prepared, your financial health can be destroyed in an instant.

112 Most people are able to get the health insurance they need through
their jobs. Lucky for them! But many people have to buy their own health insurance, for a variety of reasons (for example, they’re self-employed, they work for a small company that doesn’t provide health insurance, they retired before the age of 65, and so on).

113 An excellent health insurance plan must include five key ingredients:
✓ A coverage limit high enough that it won’t likely ever be exhausted, even for the most catastrophic medical expenses. ✓ An annual dollar limit you can live with on your out-of-pocket maximum. (The out-of-pocket maximum is an important feature of health insurance policies that limits your annual responsibility for your health insurance policy copayments and deductibles.) ✓ No dollar limits on types of expenses, such as dollar limits on daily room charges or dollar limits for types of surgical procedures. ✓ Freedom to see specialists without a referral. ✓ Worldwide coverage. Do most plans meet all five criteria? Nope. I estimate that less than half of the individual and group health plans sold in the United States include all five elements that make a great health insurance plan. Why do these five elements matter? Because you want a plan that won’t, even in the worst case, cause you major financial hardship — and a plan that lets you choose the most skilled care provider, especially in serious or lifethreatening situations, such as treating your 6-year-old’s leukemia, surgically removing your spouse’s brain tumor, or performing skin grafting operations after you’ve been badly burned.

114 Policy limits come in two varieties:
✓ A dollar maximum per claim: The per-claim maximum is the most the insurance company will spend for any single illness or injury. If your limit is $1 million, for example, your policy will pay up to $1 million for your injuries in a recent car accident, and then up to another million for next year’s cancer, and another million for the following year’s Parkinson’s disease. A dollar maximum per lifetime: Lifetime limits, where every dollar spent this year reduces the limit available for future years, are more common. If your lifetime limit is $1 million, your $225,000 car accident bill reduces your lifetime limit to $775,000. Then your $150,000 cancer bill reduces the $775,000 lifetime limit to $625,000, and so on. When buying health insurance, I strongly recommend a maximum policy limit of at least $1 million per claim or $3 million per lifetime (or a policy with no limits at all, if you can find one).

115 Capping your out-of-pocket costs
Most health insurance plans require some kind of copayment on your part. (A copayment is the dollar amount your policy requires you to pay toward your bills.) You may have a copay per visit (such as $25 for each office visit or $75 if you go to the emergency room). Perhaps you have a deductible of $500 a year before your coverage kicks in (meaning that you pay the first $500 of your medical expenses each year). Or maybe your policy pays 80 percent of all covered medical bills, with you responsible for the other 20 percent. Paying the per-visit copays or the deductible usually isn’t a hardship. But paying 20 percent of all your major medical bills in one year, without any limit on the possible amount of your contribution, can be. If you have a baby who’s born three months premature and who needs pediatric intensive care for a long time, your bill could run $400,000 — and your 20 percent copay would be $80,000! If your baby needs surgeries, your bill could jump to $750,000, and your 20 percent copay would be $150,000! That’s too big a risk for almost anyone to assume. Avoiding internal policy limits A good health insurance policy has only one policy limit — either a limit per claim or a limit per lifetime. It contains no other dollar limitations. Many mediocre policies contain internal limits such as $200 a day for room and board, $400 a day for intensive care, or dollar limits on specific surgeries ($4,000 for an appendectomy, $35,000 for quadruple bypass surgery, and so on). Even if the limits are adequate today (and most aren’t), in four to five years, given the rapid pace of medical cost inflation, you may end up getting only half your bill paid. Avoid like the plague any health insurance policy that contains internal policy limits on room and board, surgeries, or anything else.

116 Capping your out-of-pocket costs
Most health insurance plans require some kind of copayment on your part. (A copayment is the dollar amount your policy requires you to pay toward your bills.) You may have a copay per visit (such as $25 for each office visit or $75 if you go to the emergency room). Perhaps you have a deductible of $500 a year before your coverage kicks in (meaning that you pay the first $500 of your medical expenses each year). Or maybe your policy pays 80 percent of all covered medical bills, with you responsible for the other 20 percent. Paying the per-visit copays or the deductible usually isn’t a hardship. But paying 20 percent of all your major medical bills in one year, without any limit on the possible amount of your contribution, can be. If you have a baby who’s born three months premature and who needs pediatric intensive care for a long time, your bill could run $400,000 — and your 20 percent copay would be $80,000! If your baby needs surgeries, your bill could jump to $750,000, and your 20 percent copay would be $150,000! That’s too big a risk for almost anyone to assume. Avoiding internal policy limits A good health insurance policy has only one policy limit — either a limit per claim or a limit per lifetime. It contains no other dollar limitations. Many mediocre policies contain internal limits such as $200 a day for room and board, $400 a day for intensive care, or dollar limits on specific surgeries ($4,000 for an appendectomy, $35,000 for quadruple bypass surgery, and so on). Even if the limits are adequate today (and most aren’t), in four to five years, given the rapid pace of medical cost inflation, you may end up getting only half your bill paid. Avoid like the plague any health insurance policy that contains internal policy limits on room and board, surgeries, or anything else.

117 Making sure you don’t have
to beg to see specialists Many healthcare plans (such as many HMOs or PPOs) offer lower costs but take away your right to decide what kind of treatment you can get and whom you can get it from: ✓ Usually, you agree to get all your primary care from a small list of approved clinics where costs can be controlled more easily. ✓ You agree to seeing a specialist only if your primary physician will refer you out (which means “referral begging” to you). ✓ You agree to give the insurance company the final say on what type of procedure or treatment you can have. That’s a lot to give up for a savings of about 15 percent on your premiums. If your employer-provided group plan doesn’t offer choice, you can buy an individual major medical policy with a moderately high deductible. If you don’t like your choices under managed care, you go see whomever you want and pay just your deductible. Managed care worth considering In recent years, a managed care hybrid plan has emerged. It’s a two-tiered system. The first tier is managed care. When you go to your chosen primary doctor, you get almost 100 percent coverage — even if you see a specialist, if it’s a referral from your primary doctor. The second tier is freedom of choice: You can go to almost anyone — any specialist — no referrals needed. You just have to chip in on the extra cost (for example, a $300 deductible, plus 20 percent of the bill). When something serious is going on, the extra out-of-pocket expenses for the freedom of choice are worth every penny

118 Ensuring that you’re covered
away from home Many managed care plans don’t cover you outside your home territory, except for emergencies. Here are two stories from my own client files: ✓ Lee just bought a winter vacation condo in Arizona. (Why anyone would want to flee Minnesota’s winter wonderland of ice, snow, and subzero temperatures is beyond me.) Checking the Medicare supplement policy he owned from a local HMO, he discovered that there was no coverage for anything but emergency care outside Minnesota — a real problem for someone living five months of each year outside the state. Luckily, we moved his coverage to another Medicare supplement policy that gave him greater freedom of choice before anything serious happened. ✓ Jim and Jane’s daughter, Angela, was attending college out east. She fell and injured a knee. The emergency care was covered by their HMO policy, but follow-up care with physical therapists was not covered at all. It turns out that their otherwise excellent insurance has one major flaw: For anyone residing out-of-state part of the year, nonemergency care isn’t covered!

119 Saving Money on Individual Coverage
You can cut costs on individual plans in three ways: ✓ You can reduce your coverage and the insurance company will give you a direct premium credit. ✓ You can put money into a health savings account (HSA) combined with an approved high-deductible health plan (HDHP). A HDHP is a highdeductible major medical policy that meets the requirements of the IRS for use in conjunction with an HSA. (See “Saving with health savings accounts,” later in this chapter, for more information). ✓ You can opt for a higher deductible when your health and self-care are exceptional but when the insurance company has no way of lowering your premiums. Changing your coverage You can save money on your insurance by cutting out unneeded coverage. For example, if your individual policy currently includes coverage for maternity, and you know you’re not going to need it, you can drop that coverage and save money on your insurance premium. You can also cut back on doctor choice — by switching to an HMO from a PPO, for example. Socking away money in a health savings account An HSA operates like an individual retirement account (IRA) coordinated with an IRS-approved high-deductible major medical health insurance plan (HDHP). The big advantage of an HSA is that it allows you to pay for your major medical deductible as well as elective medical and dental expenses with pretax dollars. For most people, that’s equal to a 25 percent to 30 percent savings on their medical and dental bills!

120 Here’s how an HSA works:
✓ As with an IRA, contributions are income tax deductible. ✓ Earnings on the account are tax sheltered. ✓ The maximum contribution per year is set annually by the government. For each person age 55 and older, an additional “catch-up” contribution is allowed. To find out what the current allowable amounts are, as well as anything else you want to know about health savings accounts, go to and click on the Health Savings Account link. ✓ In order for the HSA contributions to be tax-deductible, you must also have an IRS-approved high-deductible health plan (HDHP). The HDHP must include options for a minimum deductible and a maximum deductible set by the government each year. There usually is a cumulative family deductible amount for policies insuring two or more people in the family. There is no coverage under the policy until the entire family reaches the family deductible in a calendar year. (Be careful when choosing your family deductible!) There generally is an option for 80 percent coverage as well as 100 percent coverage after the deductible is satisfied. Choose the 100 percent option. After you’ve satisfied the high deductible in a calendar year, you’ll have peace of mind knowing that all covered expenses will be 100 percent paid, for the rest of the year. ✓ From the HSA, you can pay your deductibles and most other medical and dental expenses that your health plan doesn’t cover (such as laser eye surgery, glasses, contact lenses, hearing aids, and dental work).

121 Because the HSA money has never been taxed, you’re paying those bills
with pretax dollars — a huge advantage. ✓ If you’ve stayed reasonably healthy, you can leave unused funds on deposit and either use them in future years or save them as supplemental retirement dollars. If you don’t use them for medical bills, withdrawals are taxed much like traditional IRAs when you do retire. You can set up an HSA wherever you can establish an IRA — banks, savings and loans, investment houses, insurance companies, and so on. Because of the need to write checks to pay doctors and buy prescription drugs, I’ve found that banks work best — that way, you can have an account with both checks and a debit card. ✓ Don’t pay any medical bill or pharmacy charge until your insurance company has reduced the cost to its negotiated discount pricing. ✓ Fund the account early in the year so you have plenty of cash available if medical bills are sizable in the first quarter of the year. ✓ Keep all your receipts for all services you’ve paid through your HSA (medical bills, pharmaceutical bills, dental bills, and so forth) in a medical folder in case you ever get audited. For a complete and current list of IRS-approved medical and dental expenses, go to and search for Publication 502, or call to have it mailed to you.) Taking care of yourself and opting for higher deductibles

122 The best way to save money on an individual policy, without cutting back on
coverage, is to quit smoking. Unlike group policies, almost all individual policies differentiate smokers from nonsmokers — significantly — because the claims costs for smokers are much higher. Insurance companies don’t offer individual health insurance to people who are high-risk medically. So, everyone else — from the super-fit and superhealthy to the average or below-average health risk — pays the same rate and shares the losses. If you’re healthy and take good care of yourself (through exercise, diet, stress management, rest, and personal safety), how can you get credit if insurance companies don’t offer any? The answer: Opt for higher deductibles. The difference in cost between a $300 deductible and a $1,000 deductible with some insurers is a whopping 45 percent! As the size of your family or age increases, that 45 percent can save you a fortune — especially when you consider that you’re assuming only $700 more risk per person each year. If you’re paying $4,000 a year for just yourself, 45 percent would save you $1,800 in premiums! Pricing for each level of deductible is based on average risk. If you’re much fitter and healthier than average, you’re paying more than your share, no matter what level of coverage you buy. But the higher your deductibles, the more you’ll save. Being above average in terms of health,

you’re willing to take one or more of the following actions, you can prevent a financial catastrophe from happening to you because of an uninsured family member: ✓ If your employer doesn’t offer group coverage, talk to them about starting to offer a group plan. Enlist the support of your coworkers. The Health Insurance Portability and Accountability Act of 1996 (HIPAA) requires insurance companies to accept all members of a group, regardless of health. If your employer adds group health insurance coverage, the worst-case scenario is that the condition won’t be covered for the first 12 months. (See Chapter 19 for more information on preexisting conditions.) ✓ Change employers. Get a job with a company that offers group medical coverage to its employees and their families. ✓ If you’re in a state that has a major medical insurance plan for uninsurable people, sign up immediately. Call your state insurance department to find out. ✓ Move to a state that offers catastrophic individual major medical coverage for uninsurable citizens. Minnesota, where I live, has such a plan, and so do many other states.

124 When you’re broke If you’re in a financial crisis — temporary or permanent — and you just don’t have enough money available for health insurance, you can still protect yourself somewhat by managing your medical risks in advance. If you don’t develop a game plan for handling medical costs before you’re faced with them, you may end up being personally responsible for the entire cost of any emergency care that you need. Look into various assistance programs in which medical care is provided either at no cost or at a nominal cost. In my community, for example, programs are available through Lutheran Social Services or Catholic Charities. In exchange for a very small amount of money per month, all family members receive the medical care they need. Participants are limited to designated medical facilities, but they get medical care now, without facing a huge debt later. Also check in your area for free clinics. If you or a family member is in economic distress, research what’s available in your community now and have an emergency plan so that you know where you’re going for care if and when you need it. A medical emergency isn’t the time to figure out what your options are.

125 GROUP COVERAGE The good news about group health insurance is that somebody else is paying part of the premium. The bad news is that your plan choices are somewhat restricted, and the coverage stays with the job when you leave. In this chapter, I help you make good choices about group health insurance while you’re employed and offer my recommendations about continuing your coverage after you leave. Choosing between two or more plans I often get calls from clients who want help choosing among group insurance options offered to them at work. Having multiple options is especially common with large employers or the government. If your employer offers more than one group health insurance option, I recommend that you do the following: ✓ Consider price last. The only exception to this rule is if your finances are in poor condition. Otherwise, set aside cost for now. ✓ Look at the five ingredients of a good health insurance plan and see how the insurance options you have to choose from compare. With any luck, at least one of the available plans includes all five ingredients. If it does, take that one. If two or more plans include all five ingredients, choose the one that also has paperless claims (meaning the doctors and hospitals file the claims directly to the insurance company). If two or more plans also offer paperless claims, then, and only then, decide on price.

126 Suppose your employer offers these three choices for group health plans for
your family of four: ✓ Option A is a true freedom-of-choice plan where you can go anywhere you want for care. The only drawback is that you have to file your own claims. Your monthly cost is $750. ✓ Option B is a limited-choice managed-care plan. It meets only one of the five key criteria of a good plan — it has a limit on annual out-of-pocket expenses. Its only advantage is low cost — $475 per month. ✓ Option C is a hybrid of A and B. You can get care anywhere without a referral. Its only drawback is that if you go outside the rather substantial primary-care network (86 percent of the doctors in the state), you’ll face a $300 deductible and probably will have to file your own claim. Your cost is $650 per month.

127 If these were your choices, you’d choose Option B only if, due to poor
finances, price was all-important. It meets only one of the five criteria of a good plan. You’d choose Option A if access to any doctor anywhere was worth the extra $1,200 a year and you could stand to file your own claims. Personally, I would choose Option C. (In fact, these were my choices, and I did choose C.) It meets all five criteria of a good plan, and claims are paperless. I’m comfortable with the doctors who are available to me, and I can actually go to any other doctor if I’m okay with higher copays and filing my own claims. To help you make a good decision, if you’re still unclear about what choice to make, consider spending $100 to $200 to consult with a good insurance agent you know who is an expert on health insurance — maybe the agent who helped you with your life insurance. Bring in your group insurance Continuing Coverage When (COBRA) You Leave Your Job Since 1985, the federal government has taken steps to allow employees and dependents to continue their health insurance when they would otherwise have lost it due to terminated employment, divorce, or other life events. The government’s goal has been to try to make group health insurance portable, especially for those whose medical history would not allow them to qualify for individual health policies. In this section, I fill you in on two federal laws that may give you some insurance continuation rights when you lose your group health coverage, and I offer advice on when to exercise those rights

HIPAA: For When COBRA Ends The Health Insurance Portability and Accountability Act (HIPAA) was created to give people who are losing their group coverage and who have preexisting medical conditions the right to continued health coverage without preexisting- condition exclusions applying to their replacement policy. The intent of the law is to prevent “job lock,” where an employee is stuck in a dead-end job in order to keep the health coverage, because he or a family member has a preexisting medical condition (defined by HIPAA as any condition treated by doctors or medication in the last six months). HIPAA makes it possible for an employee leave a job and take a new job with group medical coverage, with the assurance that the health issues of everyone in the family are immediately covered under the new group policy. HIPAA also makes it possible for an individual to leave the group policy and buy a private policy without preexisting- condition limitations or having to qualify medically, providing that your COBRA option, if any, has been exercised and the time frame exhausted (in other words, you’ve stuck with COBRA as long as it was available to you). The federal government has left it up to each state to determine exactly what type of individual health product is made available. The only condition is that there can be no preexisting condition waiting period or exclusion — preexisting conditions have to be covered immediately, provided that everyone being covered has had consecutive coverage for the past 12 months with no lapse in coverage of more than 63 days.

129 Social Security Long-Term Disability
When you think Social Security, you probably think retirement program. You may think survivor benefits for children. But few people realize that Social Security also includes disability benefits that start after 5 months of total disability if that disability is expected to last 12 months or more or result in death. Benefits are payable to your normal retirement age. If you’ve been paying into the Social Security system, every year you get a statement of estimated benefits. That statement includes your estimated retirement benefits, as well as your estimated long-term disability benefits. Don’t rely strictly on Social Security to meet your need for income replacement following a disability. In fact, I generally recommend that you ignore Social Security so that, if you do qualify for benefits, they’ll be a little extra cushion for you State Health Insurance Pools Whenever you apply for an individual health policy, there are four possible outcomes: ✓ Your application is approved. ✓ Your application is denied. ✓ Your application is approved at higher rates because of preexisting conditions (such as diabetes).

130 ✓ Your application is approved, but an exclusionary rider is attached to
the policy excluding coverage for a preexisting condition (such as a bad back, bad knees, and so on). Many states have created health insurance pools that ensure people with preexisting health conditions who can’t get health insurance or can’t get it without surcharged pricing or exclusionary riders. If you or a family member is facing that predicament, check with your state insurance department to see if your state has such a pool. Or go online to the National Association of State Health Insurance Plans at Medicaid Backed by the federal government and administered by the states, Medicaid is a health insurance program that provides medical assistance to those in need — people at or near poverty levels. Medicaid also provides long-term care for those with little or no assets. It is of particular interest to middleclass Americans who need long-term care but don’t have insurance coverage for that. In that case, they end up spending down all their assets to near poverty levels, at which point Medicaid will pick up the costs of any ongoing care for the rest of their lives. The tragedy is that, by spending down all your assets, little (if anything) is left for your surviving spouse or children.

131 MEDICARE: Otherwise known as national health insurance for seniors, Medicare provides
a base level of hospital and medical benefits. In 2003, optional prescription drug coverage (known as Part D) was added. Medicare is funded by a combination of premium payments from seniors and payroll taxes from nonseniors. In addition to the three parts of Medicare — Part A (hospital), Part B (medical), and Part D (drugs) — most seniors will want a good Medicare supplement policy to pay most of what Medicare doesn’t cover or disallow. For more information on Medicare, go to gov.

132 MORTGAGES Buying a home is the embodiment of the American dream. However, that wasn’t always the case: In fact, before the 1930s, only four in 10 American families owned their own home. That’s because very few people had enough cash to buy a home in one lump sum. And until the 1930s, there was no such thing as a bank loan specifically designed to purchase a home, something we now know as a mortgage. In simple terms, a mortgage is a loan in which your house functions as the collateral. The bank or mortgage lender loans you a large chunk of money (typically 80 percent of the price of the home), which you must pay back -- with interest -- over a set period of time. If you fail to pay back the loan, the lender can take your home through a legal process known as foreclosure. For decades, the only type of mortgage available was a fixed-interest loan repaid over 30 years. It offers the stability of regular -- and relatively low -- monthly payments. In the 1980s came adjustable rate mortgages (ARMs), loans with an even lower initial interest rate that adjusts or “resets” every year for the life of the mortgage. At the peak of the recent housing boom, when lenders were trying to squeeze even unqualified borrowers into a mortgage, they began offering “creative” ARMs with shorter reset periods, tantalizingly low “teaser” rates and no limits on rate increases. When you couple bad loans with a bad economy, you get rampant foreclosures. Since 2007, more than 250,000 Americans have entered foreclosure proceedings every month [source: Levy]. Now those foreclosures are turning into full-on repossessions, which are expected to reach 1 million homes in 2010 [source: Veiga]. Looking back at the flood of foreclosures since the housing crash, it’s clear that many borrowers didn't fully understand the terms of the mortgages they signed. According to one study, 35 percent of ARM borrowers did not know if there was a cap on how much their interest rate could rise [source: Pence]. This is why it’s essential to understand the terms of your mortgage, particularly the pitfalls of “nontraditional” loans.

133 In legal terms, a mortgage is "the pledging of property to a creditor as security for the payment of a debt" [source:]. In plain English, a mortgage is a loan. For many people, it's the biggest loan they will ever borrow. With a regular loan, there's no explicit collateral. The lender looks at your credit history, your income and your savings, and determines if you're a good risk. With a mortgage, the collateral for the loan is the house itself. If you don't pay back the loan (along with all of the fees and interest that are included with it), then the lender can take your house. Banks are the traditional mortgage lender. You can either apply for a mortgage at the bank you use for your checking and savings accounts, or you can shop around to other banks for the best interest rates and terms. If you don't have the time to shop around yourself, you can work with a mortgage broker, who sifts though different lenders to negotiate the best deal for you. Banks aren't the only source of mortgages, though: Credit unions, some pension funds and various government agencies also offer mortgages. Like other loans, mortgages carry an interest rate, either fixed or adjustable, and a length or "term" of the loan, anywhere from five to 30 years. Unlike most other loans, mortgages carry a lot of associated costs and fees. Some of those fees only happen once, such as closing costs, while others are tacked onto the mortgage payment every month.

134 It was only in the 1930s, however, that mortgages actually got their start. It may surprise you to learn that banks didn't forge ahead with this new idea; insurance companies did. These daring insurance companies did this not in the interest of making money through fees and interest charges, but in the hopes of gaining ownership of properties if borrowers failed to keep up with the payments. It wasn't until 1934 that modern mortgages came into being. The Federal Housing Administration (FHA) played a critical role. In order to help pull the country out of the Great Depression, the FHA initiated a new type of mortgage aimed at the folks who couldn't get mortgages under the existing programs. At that time, only four in 10 households owned homes. Mortgage loan terms were limited to 50 percent of the property's market value, and the repayment schedule was spread over three to five years and ended with a balloon payment. An 80 percent loan at that time meant your down payment was 80 percent -- not the amount you financed! With loan terms like that, it's no wonder that most Americans were renters. FHA started a program that lowered the down payment requirements. They set up programs that offered 80 percent loan-to-value (LTV), 90 percent LTV, and higher. This forced commercial banks and lenders to do the same, creating many more opportunities for average Americans to own homes. The FHA also started the trend of qualifying people for loans based on their actual ability to pay back the loan, rather than the traditional way of simply "knowing someone." The FHA lengthened the loan terms. Rather than the traditional five- to seven-year loans, the FHA offered 15-year loans and eventually stretched that out to the 30-year loans we have today. Another area that the FHA got involved in was the quality of home construction. Rather than simply financing any home, the FHA set quality standards that homes had to meet in order to qualify for the loan. That was a smart move; they wouldn't want the loan outlasting the building! This started another trend that commercial lenders eventually followed. Before FHA, traditional mortgages were interest-only payments that ended with a balloon payment that amounted to the entire principal of the loan. That was one reason why foreclosures were so common. FHA established the amortization of loans, which meant that people got to pay an incremental amount of the loan's principal amount with each interest payment, reducing the loan gradually over the loan term until it was completely paid off.

135 the Mortgage Payment The down payment on a mortgage is the lump sum you pay upfront that reduces the amount of money you have to borrow. You can put as much money down as you want. The traditional amount is 20 percent of the purchasing price, but it's possible to find mortgages that require as little as 3 to 5 percent. The more money you put down, though, the less you have to finance -- and the lower your monthly payment will be. The monthly mortgage payment is composed of the following costs, appropriately known by the acronym PITI: Principal - The total amount of money you are borrowing from the lender (after your down payment) Interest - The money the lender charges you for the loan. It's a percentage of the total amount of money you're borrowing. Taxes - Money to pay your property taxes is often put into an escrow account, a third-party entity that holds accumulated property taxes until they're due. Insurance - Most mortgages require the purchase of hazard insurance to protect against losses from fire, storms, theft, floods and other potential catastrophes. If you own less than 20 percent of the equity in your home, you may also have to buy private mortgage insurance, which we'll talk more about later. With a fixed-rate mortgage, your monthly payment remains roughly the same for the life of the loan. What changes from month to month and year to year is the portion of the mortgage payment that pays down the principal of the loan and the portion that is pure interest. The gradual repayment of both the original loan and the accumulated interest is called amortization. If you look at the amortization schedule for a typical 30-year mortgage, the borrower pays much more interest than principal in the early years of the loan. For example, a $100,000 loan with a 6 percent interest rate carries a monthly mortgage payment of $599. During the first year of mortgage payments, roughly $500 each month goes to paying off the interest; only $99 chips away at the principal. Not until year 18 does the principal payment exceed the interest. The advantage of amortization is that you can slowly pay back the interest on the loan, rather than paying one huge balloon payment at the end. The downside of spreading the payments over 30 years is that you end up paying $215,838 for that original $100,000 loan. Also, it takes you longer to build up equity in the home, since you pay back so little principal for so long. Equity is the value of your home minus your remaining principal balance. But that doesn't mean that fixed-rate, 30-year mortgages are a bad thing. Far from it.

136 Fixed-rate Mortgages Not that long ago, there was only one type of mortgage offered by lenders: the 30-year, fixed-rate mortgage. A fixed-rate mortgage offers an interest rate that will never change over the entire life of the loan. Not only does your interest rate never change, but your monthly mortgage payment remains the same for 15, 20 or 30 years, depending on the length of your mortgage. The only numbers that might change are property taxes and any insurance payments included in your monthly bill. The interest rates tied to fixed-rate mortgages rise and fall with the larger economy. When the economy is growing, interest rates are higher than during a recession. Within those general trends, lenders offer borrowers specific rates based on their credit history and the length of the loan. Here are the benefits of 30, 20 and 15-year terms: 30-year fixed-rate -- Since this is the longest loan, you'll end up paying the most in interest. While that might not seem like a good thing, it also allows you to deduct the most in interest payments from your taxes. This long-term loan also locks in the lowest monthly payments. 20-year fixed-rate -- These are harder to find, but the shorter term will allow you to build up more equity in your home sooner. And since you'll be making larger monthly payments, the interest rate is generally lower than a 30-year fixed mortgage. 15-year fixed-rate -- This loan term has the same benefits as the 20-year term (quicker payoff, higher equity and lower interest rate), but you'll have an even higher monthly payment. There is a long-term stability to fixed-rate mortgages that many borrowers find attractive-- especially those who plan on staying in their home for a decade or more. Other borrowers are more concerned with getting the lowest interest rate possible. This is part of the attraction of adjustable-rate mortgages,

137 Adjustable-rate Mortgages
An adjustable-rate mortgage (ARM) has an interest rate that changes -- usually once a year -- according to changing market conditions. A changing interest rate affects the size of your monthly mortgage payment. ARMs are attractive to borrowers because the initial rate for most is significantly lower than a conventional 30-year fixed-rate mortgage. Even in 2010, with interest rates on the 30-year fixed mortgage at historic lows, the ARM rate is almost a full percentage point lower [source: Haviv]. ARMs also make sense to borrowers who believe they'll be selling their home within a few years. If you're considering an ARM, one important thing to remember is that intentions don't always equal reality. Many ARM borrowers who intended to sell their homes quickly during the real estate boom were instead stuck with a "reset" mortgage they couldn't afford. Many of them never fully understood the terms of their ARM agreement. Here are the key numbers to look for: How often your interest rate adjusts -- A conventional ARM adjusts every year, but there are also six-month ARMs, one-year ARMs, two-year ARMs and so on. A popular "hybrid" ARM is the 5/1 year ARM, which carries a fixed rate for five years, then adjusts annually for the life of the loan. A 3/3 year ARM has a fixed rate for the first three years, then adjusts every three years. There will also be caps, or limits, to how high your interest rate can go over the life of the loan and how much it may change with each adjustment. Interim or periodic caps dictate how much the interest rate may rise with each adjustment and lifetime caps specify how high the rate can go over the life of the loan. Never sign up for an ARM without any caps! The interest rates for ARMs can be tied to one-year U.S. Treasury bills, certificates of deposit (CDs), the London Inter-Bank Offer Rate (LIBOR) or other indexes. When mortgage lenders come up with their ARM rates, they look at the index and add a margin of two to four percentage points. Being tied to these index rates means that when those rates go up, your interest goes up with it. The catch? If interest rates go down, the rate on your ARMs may not [source: Federal Reserve]. In other words, read the fine print.

138 Other Types of Mortgages
Let's start with a risky type of mortgage called a balloon mortgage. A balloon mortgage is a short-term mortgage (five to seven years) that's amortized as if it's a 30-year mortgage. The advantage is that you end up making relatively low monthly payments for five years, but here's the kicker. At the end of those five years, you owe the bank the remaining balance on the principal, which is going to be awfully close to the original loan amount. This "balloon" payment can be a killer. If you can't flip or refinance the home in five years, you're out of luck. Reverse mortgages actually pay you as long as you live in your home. These loans are designed for homeowners age 62 and older who need an inflow of cash, either as a monthly check or a line of credit. Essentially, these homeowners borrow against the equity in their homes, but they don't have to pay the loan back as long as they don't sell their homes or move. The downside is that the closing costs can be very high, and you still have to pay taxes and mortgage insurance [source: Moore]. Three agencies of the federal government work with lenders to offer discounted rates and loan terms for qualifying borrowers: Federal Housing Administration (FHA), which is part of the U.S. Department of Housing and Urban Development, the Veterans Administration (VA) and the Rural Housing Service (RHS), which is a branch of the U.S. Department of Agriculture. These agencies don't directly lend money to borrowers. Rather, they insure the loans made by approved mortgage lenders. This includes the refinancing of mortgages that have become unaffordable. Borrowers with bad credit histories might find it easier to secure a loan from an FHA-approved lender, since the lender knows that if the borrower fails to pay back the loan, the government will pick up the bill. FHA loans only require a 3 percent down payment, all of which can come from a family member, employer or charitable organization [source: HUD]. Commercial mortgages wouldn't allow that. Veterans Administration loans, like FHA loans, are guaranteed by the agency, not lent directly to borrowers.VA-backed loans offer generous terms and relaxed requirements to qualified veterans. Vets can pay no money down as long as the home price doesn't exceed the loan limits for the county. If you live in a rural area or small town, you may qualify for a low-interest loan through the Rural Housing Service. RHS offers both guaranteed loans through approved lenders and direct loans that are government funded. Theyenable low-income families to get loans for homes.

139 Understanding APR Probably one of the most confusing things about mortgages and other loans is the calculation of interest. With variations in compounding, terms and other factors, it's hard to compare apples to apples when comparing mortgages. Sometimes it seems like we're comparing apples to grapefruits. For example, what if you want to compare a 30-year fixed-rate mortgage at 7 percent with one point to a 15-year fixed-rate mortgage at 6 percent with one-and-a-half points? First, you have to remember to also consider the fees and other costs associated with each loan. How can you accurately compare the two? Luckily, there's a way to do that. Lenders are required by the Federal Truth in Lending Act to disclose the effective percentage rate, as well as the total finance charge in dollars. The annual percentage rate (APR) that you hear so much about allows you to make true comparisons of the actual costs of loans. The APR is the average annual finance charge (which includes fees and other loan costs) divided by the amount borrowed. It is expressed as an annual percentage rate -- hence the name. The APR will be slightly higher than the interest rate the lender is charging because it includes all (or most) of the other fees that the loan carries with it, such as the origination fee, points and PMI premiums. Here's an example of how the APR works. You see an advertisement offering a 30-year fixed-rate mortgage at 7 percent with one point. You see another advertisement offering a 30-year fixed-rate mortgage at 7 percent with no points. Easy choice, right? Actually, it isn't. Fortunately, the APR considers all of the fine print. Say you need to borrow $100,000. With either lender, that means that your monthly payment is $ If the point is 1 percent of $100,000 ($1,000), the application fee is $25, the processing fee is $250, and the other closing fees total $750, then the total of those fees ($2,025) is deducted from the actual loan amount of $100,000 ($100,000 - $2,025 = $97,975). This means that $97,975 is the new loan amount used to figure the true cost of the loan. To find the APR, you determine the interest rate that would equate to a monthly payment of $ for a loan of $97,975. In this case, it's really 7.2 percent.

140 The Origination Fee The origination fee is how lenders make money up front on your mortgage loan. Origination fees are calculated as a percentage of the total loan, usually between 0.5 and 1 percent on U.S. mortgages [source: Investopedia]. Going back to our APR example, let's say that the second lender charges a 3 percent origination fee, plus an application fee and other costs totaling $3,820 at closing. That brings the new loan amount down to $96,180, which yields an APR of 7.39 percent. So there you have it: Although the second lender advertised no points, it ended up with a higher APR because of its steep origination fee. The take home message is simple: Don't just look at the interest rate. Ask for the APR and compare it with other lenders. Also, make sure you know which fees are being included in the APR calculation. Typically, these include origination fees, points, buydown fees, prepaid mortgage interest, mortgage insurance premiums, application fees and underwriting costs. But note that some fees are charged by all lenders and are non-negotiable, such as title insurance and appraisals. Luckily, you don't have to calculate the APR on your own. The lender will give it to you when it gives you the Federal Truth in Lending Disclosure; you just have to understand its importance. Here are some other things to take into account when you examine the APR: The more you borrow, the less impact all of those fees will have on the APR, since the APR is calculated based on the total loan amount. The length of time you're actually in the home before you sell or refinance directly influences the effective interest rate you ultimately get. For example, if you move or refinance after three years instead of 30, after having paid two points at the loan closing, your effective interest rate for the loan is much higher than if you stay for the full loan term.

141 Qualifying for a Loan In order to qualify for a mortgage, most lenders require that you have a debt-to-income ratio of 28/36 (this can vary depending on the down payment and the type of loan you're getting, however). This means that no more than 28 percent of your total monthly income (from all sources and before taxes) can go toward housing, and no more than 36 percent of your monthly income can go toward your total monthly debt (this includes your mortgage payment). The debt they look at includes any longer-term loans like car loans, student loans, credit cards or any other debts that will take a while to pay off. Here's an example of how the debt-to-income ratio works: Suppose you earn $35,000 per year and are looking at a house that would require a mortgage of $800 per month. According to the 28 percent limit for your housing, you could afford a payment of $816 per month, so the $800 per month this house will cost is fine (27 percent of your gross income). Suppose, however, you also have a $200 monthly car payment and a $115 monthly student loan payment. You have to add those to the $800 mortgage to find out your total debt. These total $1,115, which is roughly 38 percent of your gross income. That makes your housing-to-debt ratio 27/38. Lenders typically use the lesser of the two numbers, in this case the 28 percent $816 limit, but you may have to come up with a bigger down payment or negotiate with the lender. You also have to think about what you can afford. The lender will tell you what you can afford based on the lower number in the debt-to-income ratio, but that's not taking any of your regular expenses (like food) into account. What if you have an expensive hobby or have plans for something that will require a lot of money in five years? Your lender doesn't know about that, so the $1,400 mortgage it says you qualify for today may not fit your actual budget in five years -- particularly if you don't see your income increasing too much over that period. Take a look at this calculator to see how much house you can afford based on your current income. In general, it's more difficult to qualify for a mortgage now than it was during the housing boom, when just about any motivated homebuyer could find credit -- even many who couldn't afford to buy a house.

142 Mortgage Application A lender will look at your employment history and credit history as indicators of how likely you are to pay back your loan. Lenders want to see stability, which means they will look closely any late payments during the last two years of your credit history. They will pay particular attention to any rent or mortgage payments that were more than 30 days past due. They'll also look at late payments for credit cards during the last six months. Stable income is also important. Lenders look for steady employment with a single employer for the past two years (or at least employment in the same field). Other income -- such as earnings from part-time or freelance work, overtime, bonuses or self-employment -- is also acceptable if it has a two-year history. If you don't meet the minimum requirements, that doesn't mean you'll never quality for a mortgage. You may just have to talk to more lenders or settle for a higher interest rate. The entire credit market has been tight for several years now. Mortgage lenders give the best interest rates to borrowers with high credit scores (760 to 850) who can make a big down payment (10 to 20 percent) [source: Esswein]. Here is a typical list of the documents you need when applying for a mortgage: Money for the closing costs Completed sales contract signed by buyers and sellers Social Security numbers of all applicants Complete address for the past two years (including complete name and address of landlords for past 24 months) Names, addresses and all income earned from all employers for past 24 months W-2 forms for the two years prior to your loan application Most recent pay stub showing year-to-date earnings Names, addresses, account numbers, monthly payments and current balances for all loans and charge accounts Names, addresses, account numbers and balances for all deposit accounts, such as checking accounts, savings accounts, stocks and bonds The last three statements for deposit accounts, stocks and bonds If you choose to include income from child support and/or alimony, bring copies of court records of cancelled checks showing receipt of payment. A more detailed list can be found here. Your lender and closing attorney will also tell you what paperwork and documents you will need to present at the loan closing.

143 What Are Closing Costs? The total cost of a home mortgage is much more than just the monthly mortgage payments. Once a sales contract is signed, the closing process begins. As part of the closing, the deed and title are transferred to the buyer, title insurance and financing documents are exchanged and copies are delivered to the county recorder. Since the closing is a legal process, it often involves an attorney or at least a third-party escrow holder. All of these processes and professionals cost money, adding up to a surprisingly large sum known as the closing costs. The amount of money you'll have to pay in closing costs varies a lot by region. If you live in a highly taxed area, for example, your closing costs will be higher. Also, realtors, lenders and attorneys have differing fee scales depending on the markets they work in. Typically, you will pay anywhere from 3 to 6 percent of your total loan amount in closing costs -- that means $3,000 to $6,000 if you get a $100,000 loan. Of course, you can and should shop around and negotiate the fees. The Real Estate Settlement Procedures Act requires lenders to provide you with a good faith estimate of closing costs within three days of receiving your application. As you can see from the list covering the next few pages, there are a lot of fees that you might be able to convince the lender to lower or drop. You may also be able to negotiate for the seller to pay some of the closing costs. The fees for services involved in closing a mortgage fall into three categories: the actual cost of getting the loan, the fees involved in transferring ownership of the property and the taxes paid to state and local governments.

144 List of Closing Costs, Part I
Here are some of the major fees included closing costs: Processing fee --This is what the lender charges to cover initial loan processing costs. It includes the application and credit report access fees. These charges are usually around $400 to $550. Something to watch for when comparing lenders: Sometimes the credit report fee will be listed separately from the processing fee. Appraisal fee -- Because the lender wants to make sure the property is worth what you are paying for it, it requires an appraisal. An appraisal compares the value of the property to similar properties in the same neighborhood. These services are performed by independent appraisers and usually cost around $250 or more depending on the price of the property. Origination fee -- In addition to the application or processing fee, the lender may also charge an origination fee. This covers the additional work the lender has to do when preparing your mortgage. The charge may be a flat fee or a percentage of the mortgage. If the fee is a percentage of the loan, then it is typically considered a "discount point" in disguise. This changes the tax implications and your costs, so be sure to ask the lender about this fee. Discount points -- Buying discount points means that you're buying "down" the interest rate you'll be paying. One discount point equals 1 percent of the loan amount. These points are paid either when the loan is approved or at closing. Buying points can save a lot of money in interest payments over the life of the loan, so investigate it when you're shopping around. Some lenders will let you add the cost of the points to your mortgage, or you may have the option of paying for them up front. You can also deduct those points from your federal income tax. For more information about what is tax deductible, click here. Document preparation fee -- This charge may be included in the application or attorney's fee. It pays for the preparation of the mound of documents that have to be prepared and is usually a flat rate, but can also be charged as a percentage of the loan amount -- usually less than 1 percent.

145 List of Closing Costs, Part II
If you thought you were done with closing costs, think again: Attorney fees -- Both you and your lender will incur attorney fees. This charge ensures that your lawyer draws up the necessary documents and sets everything up properly for the closing. Your own closing attorney will represent your interests and may be present at, or may facilitate, the closing itself. The closing attorney collects all fees, transfers the deed to the buyer, pays outstanding taxes and utility bills, pays himself and all other closing costs and gives all remaining money to the seller. The attorney fees may range from $500 to $1,000 or more, depending on the purchase price of the property and the complexity of the sale. Home and pest inspections -- Your lender will probably require that the home be inspected to make sure it's both structurally sound and free of termites and other destructive insects. You may also have to have the water tested if the property uses a well rather than city tap water. In some areas, the water test means checking only the quantity of water available to the house, rather than the quality. If this is the case, you may want to have your own water quality test done. Homeowner's and hazard insurance -- You'll have to have these policies in place (and the first year's premium prepaid) at the time of the closing in most states. This insurance protects your (and the lender's) investment if the house is destroyed. Private mortgage insurance (PMI) -- If your down payment is less than 20 percent of the value of the house, you may be required to purchase mortgage insurance. This protects the lender in case you fail to make your mortgage payments. Premiums will usually be a part of your monthly mortgage payment and will be transferred into the same escrow account your taxes and homeowner's insurance fees are paid into. You have to pay these PMI premiums until you reach the 20 or 25 percent requirement -- or, they can go on for the life of the loan. (See the next section for more details on PMI.) Surveys -- Many lenders will require that the land be independently surveyed. This is just to ensure that there haven't been any changes, like new structures or encroachments on the property, since the last survey. These usually run $250 to $500.

146 List of Closing Costs, Part III
Yes, there are more: Prepaid interest -- Although your first payment won't be due for six to eight weeks, the interest starts accruing the day you close the sale. The lender calculates the interest due for that fraction of a month before your first official mortgage payment. It's a good strategy to plan your closing for the end of the month to reduce the amount of prepaid interest you'll owe. Deed recording fees -- These fees, usually around $50, pay the county clerk to record the deed and mortgage and change the billing information for property taxes. Title search fees -- A title search ensures that the person saying he or she owns the property is the legitimate owner. A title company closely examines public records such as deeds, records of death, court judgments, liens, contests over wills and other documents that could affect ownership rights. This is an important step in closing your loan because it assures that there are no outside claims against the property. The fees charged for title searches, usually between $300 and $600, are based on a percentage of the property cost. Title insurance -- If the title company misses something during the title search, you'll be glad you have title insurance. Title insurance protects you from having to pay the mortgage on a property you no longer legally own. Lenders require title insurance to protect their investment, but you may also want to get your own policy. Title insurance has only a onetime fee that covers your property for the entire length of time you or your heirs own it (usually 0.2 to 0.5 percent of the loan amount for lender's title insurance, and 0.3 to 0.6 percent for owner's title insurance). It's also one of the least expensive types of insurance. If the previous owner of the property owned it for only a few years, you may be able to get title insurance at a "re-issue" rate, which is usually lower than the regular rate. Closing Taxes -- Depending on the state you live in, you will have to pay anywhere from three to eight (or more) months' taxes at the closing, or place the money in an escrow account for later payments throughout the year. These include prorated school taxes, municipal taxes and any other required taxes. In some cases, you may be able to split these taxes with the seller based on when they are due. For example, you would only pay taxes for the months following the closing date up until the date the taxes had to be paid. The seller would have to pay for the months up until the closing date. Now that you've finally closed the sale -- yes, you may actually have to pay for something else

147 Private Mortgage Insurance
Private mortgage insurance (PMI) can help you snag the mortgage you want with a down payment of 20 percent or less. This is particularly helpful for younger buyers who haven't had the years to save but want to enjoy the tax benefits and investment aspects of home ownership. PMI is insurance that pays the mortgage in case you can't. It's protection for the lender, who is taking a greater risk with a borrower who has less equity. Lenders have discovered through experience and research that there is a definite correlation between the amount of money a borrower has put into the home and the rate of default on loans. The more equity in the home, the lower the rate of default. Here is an example of how it works: If a couple has $10,000 in the bank, then they can buy a $50,000 home if they have to pay a 20 percent down payment. If they don't have to pay 20 percent, then that same $10,000 can be a 10 percent down payment on a $100,000 house or a 5 percent down payment on a $200,000 house. If they opt for the more expensive house, however, they have to pay for PMI. The costs for PMI are based on the loan amount. For a $100,000 loan with a 10 percent down payment, the average cost of PMI might be $40 per month. In 1998, the Homeowners Protection Act established rules for mortgages signed on or after July 29, 1999, that require the automatic termination of PMI after you have reached 22 percent equity in the home, based on the original property value. You can also request that the PMI be dropped when you reach 20 percent if your mortgage was signed after that date. If your mortgage was signed prior to that date, you can request the cancellation of PMI once you've reached the magic 20 percent mark, but your lender isn't required by law to cancel it. There are certain conditions that may make your loan an exception to this rule -- for example, if you haven't kept your payments current, if your loan is considered high-risk or if you have other liens on the property. Note that there are some states that have laws regarding early termination of PMI for those who signed mortgages before July 29, 1998.

148 Private Mortgage Insurance
Private mortgage insurance (PMI) can help you snag the mortgage you want with a down payment of 20 percent or less. This is particularly helpful for younger buyers who haven't had the years to save but want to enjoy the tax benefits and investment aspects of home ownership. PMI is insurance that pays the mortgage in case you can't. It's protection for the lender, who is taking a greater risk with a borrower who has less equity. Lenders have discovered through experience and research that there is a definite correlation between the amount of money a borrower has put into the home and the rate of default on loans. The more equity in the home, the lower the rate of default. Here is an example of how it works: If a couple has $10,000 in the bank, then they can buy a $50,000 home if they have to pay a 20 percent down payment. If they don't have to pay 20 percent, then that same $10,000 can be a 10 percent down payment on a $100,000 house or a 5 percent down payment on a $200,000 house. If they opt for the more expensive house, however, they have to pay for PMI. The costs for PMI are based on the loan amount. For a $100,000 loan with a 10 percent down payment, the average cost of PMI might be $40 per month. In 1998, the Homeowners Protection Act established rules for mortgages signed on or after July 29, 1999, that require the automatic termination of PMI after you have reached 22 percent equity in the home, based on the original property value. You can also request that the PMI be dropped when you reach 20 percent if your mortgage was signed after that date. If your mortgage was signed prior to that date, you can request the cancellation of PMI once you've reached the magic 20 percent mark, but your lender isn't required by law to cancel it. There are certain conditions that may make your loan an exception to this rule -- for example, if you haven't kept your payments current, if your loan is considered high-risk or if you have other liens on the property. Note that there are some states that have laws regarding early termination of PMI for those who signed mortgages before July 29, 1998.

INSIDER ACTIVITY: Imagine that you’re boarding a cruise ship, ready to enjoy a hard-earned vacation. As you merrily walk up the plank, you notice that the ship’s captain and crew are charging out of the vessel, flailing their arms, and screaming at the top of their lungs. Some are even jumping into the water below. Quiz: Would you get on that ship? You get double credit if you can also explain why (or why not). What does this scenario have to do with stock investing? Plenty. The behavior of the people running the boat gives you important clues about the nearterm prospects for the boat. Similarly, the actions of company insiders can provide important clues into the near-term prospects for their company. Company insiders are key managers or investors in the company. Insiders include the president of the company, the treasurer, or another managing officer. An insider can also be someone who owns a large stake in the company or someone on the board of directors. In any case, insiders usually have a bird’s-eye view of what’s going on with the company and a good idea of how well (or how poorly) the company is doing.

150 Keep tabs on what insiders are doing, because their buy/sell transactions do
have a strong correlation to the near-term movement of their company’s stock. However, don’t buy or sell stock only because you heard that some insider did. Use the information on insider trading to confirm your own good sense in buying or selling stock. Insider trading sometimes can be a great precursor to a significant move that you can profit from if you know what to look for. Many shrewd investors have made their profits (or avoided losses) by tracking the activity of the insiders. Tracking Insider Trading Fortunately, we live in an age of disclosure. Insiders who buy or sell stock must file reports that document their trading activity with the Securities and Exchange Commission (SEC), which makes the documents available to the public. You can view these documents at either a regional SEC office (see or on the SEC’s Web site, which maintains the EDGAR (Electronic Data Gathering, Analysis, and Retrieval) database ( Just click on the “Search for Company Filings” button. Some of the most useful documents you can view there include the following: ✓ Form 3: This form is the initial statement that insiders provide. They must file Form 3 within ten days of obtaining insider status. An insider files this report even if he hasn’t made a purchase yet; the report establishes the insider’s status.

151 ✓ Form 4: This document shows the insider’s activity, such as a change
in the insider’s position as stockholder — how many shares the person bought and sold or other relevant changes. Any activity in a particular month must be reported on Form 4 by the 10th of the following month. ✓ Form 5: This annual report covers transactions that are small and not required on Form 4, such as minor, internal transfers of stock. ✓ Form 144: This form serves as the public declaration by an insider of the intention to sell restricted stock — stock that the insider was awarded, or received from the company as compensation, or bought as a term of employment. Insiders must hold restricted stock for at least one year before they can sell it. After an insider decides to sell, she files Form 144 and then must sell within 90 days or submit a new Form 144. The insider must file the form on or before the stock’s sale date. When the sale is finalized, the insider is then required to file Form 4.

152 Fighting accounting fraud: The Sarbanes-Oxley Act
Very often, a market that reaches a mania stage sees abuse reach extreme conditions as well. Abuse by insiders is a good example. In the stock market mania of 1997–2000, this abuse wasn’t just limited to insider buying and selling of stock; it also covered the related abuse of accounting fraud. (Companies like Enron in 2001 and Fannie Mae in 2008 come to mind.) The top management executives at several prominent companies deceived investors about the companies’ financial conditions and subsequently were able to increase the perceived value of the companies’ stock. The stock could then be sold at a price that was higher than market value. Congress took notice of these activities and, in 2002, passed the Sarbanes-Oxley Act (SOX). Congress designed this act to protect investors from fraudulent accounting activities by corporations. SOX established a public accounting oversight board and also tightened the rules on corporate financial reporting. Since passage of SOX, the period of 2003–2007 was relatively quiet on the corporate compliance front, but as I write this, SOX will soon be tested, as Wall Street’s financial institutions have been slammed by bankruptcy and alleged management wrongdoing.

153 Companies are required to make public the documents that track their trading
activity. The SEC’s Web site offers limited access to these documents, but for greater access, check out one of the many companies that report insider trading data, such as and The SEC has enacted the short-swing profit rule to protect the investing public. This rule prevents insiders from quickly buying the stock that they just sold at a profit. The insider must wait at least six months before buying it again. The SEC created this rule to prevent insiders from using their privileged knowledge to make an unfair profit quickly, before the investing public can react. The rule also applies if an insider sells stock — he can’t sell it at a higher price within a six-month period. Looking at Insider Transactions The classic phrase “Actions speak louder than words” was probably coined for insider trading. Insiders are in the know, and keeping a watchful eye on their transactions — both buying and selling their company’s stock — can provide you with very useful investing information. But insider buying and insider selling can be as different as day and night; insider buying is simple, while insider selling can be complicated. In the following sections, I present both sides of insider trading.

154 Breaking down insider buying
Insider buying is usually an unambiguous signal about how an insider feels about his company. After all, the primary reason that all investors buy stock is that they expect it to do well. If one insider is buying stock, that’s generally not a monumental event. But if several or more insiders are buying, those purchases should certainly catch your attention. Insider buying is generally a positive omen and beneficial for the stock’s price. Also, when insiders buy stock, less stock is available to the public. If the investing public meets this decreased supply with increased demand, the stock price rises. Keep these factors in mind when analyzing insider buying: ✓ Identify who’s buying the stock. The CEO is buying 5,000 shares. Is that reason enough for you to jump in? Maybe. After all, the CEO certainly knows how well the company is doing. But what if that CEO is just starting her new position? What if before this purchase she had no stock in the company at all? Maybe the stock is part of her employment package. The fact that a new company executive is making her first stock purchase isn’t as strong a signal urging you to buy as the fact that a longtime CEO is doubling her holdings. Also, if large numbers of insiders are buying, that sends a stronger signal than if a single insider is buying. ✓ See how much is being bought. In the preceding example, the CEO bought 5,000 shares, which is a lot of stock no matter how you count it. But is it enough for you to base an investment decision on? Maybe, but a closer look may reveal more. If she already owned 1 million shares at the time of the purchase, then buying 5,000 additional shares wouldn’t

155 be such an exciting indicator of a pending stock rise
be such an exciting indicator of a pending stock rise. In this case, 5,000 shares is a small incremental move that doesn’t offer much to get excited about. However, what if this particular insider has owned only 5,000 shares for the past three years and is now buying 1 million shares? Now that should arouse your interest! Usually, a massive purchase tells you that particular insider has strong feelings about the company’s prospects and that she’s making a huge increase in her share of stock ownership. Still, a purchase of 1 million shares by the CEO isn’t as strong a signal as ten insiders buying 100,000 shares each. Again, if only one person is buying, that may or may not be a strong indication of an impending rise. However, if lots of people are buying, consider it a fantastic indication. An insider purchase of any kind is a positive sign, but it’s always more significant when a greater number of insiders are making purchases. “The more the merrier!” is a good rule for judging insider buying. All these individuals have their own, unique perspectives on the company

156 and its prospects. Mass buying indicates mass optimism for the company’s
future. If the treasurer, the president, the vice president of sales, and several other key players are putting their wealth on the line and investing it in a company they know intimately, that’s a good sign for your stock investment as well. ✓ Notice the timing of the purchase. The timing of insider stock purchases is important as well. If I tell you that five insiders bought stock at various points last year, you may say, “Hmm.” But if I tell you that all five people bought substantial chunks of stock at the same time and right before earnings season, that should make you say, “HMMMMM!” TEN WAYS TO PROFIT BEFORE THE CROWD DOES 1. USE YOUR INSTINCTS 2. TAKE NOTICE OF PRAISE FROM CONSUMER GROUPS 3. CHECK OUT POWERFUL DEMOGRAPHICS 4. LOOK FOR A RISE IN EARNINGS 5. ANALYZE INDUSTRIES 6. STAY AWARE OF POSITIVE PUBLICITY FOR INDUSTRIES 7. STAY AWARE OF MEGATRENDS 8. KEEP TRACK OF POLITICS 9. RECOGNIZE HEAVY INSIDER OR CORPORATE BUYING 10. FOLLOW INSTITUTIONAL INVESTORS

Most economic indicators show that, at the turn of the new century, the U.S. economy was flourishing. Despite significant challenges, such as the September 2001 terror attack on America, the economy grew. For the first eight and one half years, the unemployment rates were low, generally staying below six percent. RGDP growth was positive through 2007, and consumer prices held relatively steady during the same period. Between the beginning of 2003 and late into 2007, the Dow Jones Industrial Average generally increased, reaching a peak of over 14,000 in October of Thus, the economy during the first seven or so years of the twenty-first century may be described as healthy.

158 in the fall of 2008 that most Americans, and the world, learned that an asset bubble had burst and the general economy would pay a price.1 The macroeconomic response was predictable: RGDP growth rates turned negative in 2008 and Expectedly, unemployment increased steadily beginning in April of 2008, reached over ten percent in October of 2009 and held close to ten percent for many months. The Dow Jones Industrial Average fell from its October 2007 high of over 14,000 to just under 6500 in March 2009: well over half of the index average had been lost. Between October 2007 and October 2008, eight trillion dollars in wealth was lost in the stock market.2 The U.S. plunged into a severe Recession. THE HOUSING BUBBLE House prices rosefar in excess of inflation. In some states, prices were rising, on average, over 25 percent a year (Hawaii, Arizona). In other states, house price inflation was much more modest, rising at most seven percent on average (Texas)

159 As home prices fell and mortgage borrowers had increasing difficulty
paying their loans, the vulnerability of banks was exposed. There were 267 bank failures between the turn of the century and June 1, 2010, and 88 percent of these were after the beginning of 2008. THE CAUSE OF THE HOUSINGG BUBBLE The narrative which follows explains how the housing bubble was created, how it popped, and how it led to a bank crisis in the U.S. The unprecedented rise in home prices in the U.S. was the result of a mix of public policy, monetary policy, and regulation. Blended together, the policies and regulation led to higher home prices by: significantly increasing the demand for homes and for mortgages to finance the home purchases; increasing the supply of mortgages, particularly for low-income home buyers; and restricting land use which created a scarcity of attractive new home sites. Once home prices crested and then began plummeting, the high risk nature of the mortgages was exposed.

160 Beginning in the early 1990s, the U.S. federal government, through a
series of regulatory, legislative, and policy directives, committed itself to the expansion of homeownership. To achieve this increase in ownership, public policy relied, in part, on Government Sponsored Enterprises (GSEs). In particular, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), both GSEs under the regulatory supervision of the Office of the Federal Housing Enterprise Oversight (OFHEO) which, in turn, was housed in the Housing and Urban Development (HUD) agency, were required to undertake an affordable housing mission established by Congress. As GSEs, both Fannie Mae andFreddie Mac have a unique business model. Both GSEs are owned privately by shareholders but operate with a public mission, under a congressional charter, with a line of credit at the Treasury. Consequently, the GSEs are privately owned but publically operated with the backing of the U.S. Treasury.Banks, thrifts, or mortgage companies originate the mortgage loan and then turn around and sell the loans to the GSEs.

161 Once Fannie and Freddie had purchased the mortgages they typically
had two options. Either they would hold onto the mortgages and earn the interest on them or they would package up the mortgages and sell them off to investors. If they sold the mortgages off, this would free up funds to purchase even more mortgages from banks. Further, the GSEs guaranteed the investors that they would pay the interest and principal on the mortgages, even if the borrower could not.6The GSEs were purchasing many different types of mortgages but, given the affordable housing mission, many of the mortgages were subprime. There is no universal definition of a subprime loan, but generally speaking, a subprime loan is of higher credit risk than prime loans largely because of the risk characteristics of the borrower. Subprime borrowers, for example, may have poor credit histories, high debt burdens relative to their income, or little money for down payment. Since a subprime loan carries greater risk, the interest rate on these loans is higher than on prime mortgage loans. Another category of mortgage loans, Banking and Crisis in the Twenty-First Century: 2000– known as Alt-A loans, carry risk between prime and subprime loans. The GSEs were committed to purchasing Alt-A and subprime loans as a part of their support for the affordable housing policy of the federal government.

162 Concurrent with the GSEs purchasing and reselling mortgage loans,
the Federal Reserve was pursuing a policy of low interest rates. Figure A.25 contains the federal funds rate from January 2000 through March 2010 and shows that between the end of 2000 and the middle of 2004, interest rates fell to about one percent and held at this historically low level until rising to about three percent in the middle of 2005, and finally reaching just over five percent in the middle of 2006.Low interest rates and the resulting reduced cost of borrowing fueled the increasing demand for Mortgages. State laws and federal financial and tax regulation also played an important role in driving up home prices in the 2000s. LAND USE REGULATION: States and municipalities began, in the 1960s, passing land use restrictions. These may take several forms, from restricting how land may be used (e.g. the farmer who no longer wants to farm cannot sell the land for development), to mandated minimum lot-sizes (e.g. a home must be built on at least one acre of land), to limiting the annual number of building permits.These policies and laws make land more scarce, and consequently, more expensive for home building. NONRECOURSE MORTGAGE LOANS

163 home. The borrower walks away unburdened by the debt from the
In some states, when a borrower takes out a mortgage, the home is the